Vaccinate Your Portfolio

Faith in institutions is near all-time lows. Americans don’t trust the mass media. We certainly don’t trust politicians. The internet allows each of us to construct a comfortable cocoon of congenial opinions. It appears we are each allowed to select our preferred set of “alternative facts.” Absent trusted sources of data, confirmation bias runs rampant.

Yet there remains an objective reality out there. In many disciplines there are recognized best practices that define how well-informed and prudent individuals and institutions should act; failure to follow those best practices risks adverse consequences.

Consider vaccination.

My wife is an epidemiologist trained at Johns Hopkins School of Public Health. Some of my closest friends, and many of my clients, are physicians. None of them have any doubt whatsoever that vaccination is safe and effective. All recognize the absolutely central role of vaccines in improving public health.

We no longer have thousands of children and adults confined to iron lungs because of polio. I don’t know anyone whose brother, sister, son, or daughter died of measles, mumps or whooping cough as a child. Unless the Iranians or Russians have retained live smallpox cultures, a disease that has killed millions over the centuries is gone from Planet Earth.

All because of vaccinations. Yet vaccination has become controversial because of misinformation spread on the internet. Even intelligent people, when struggling with a personal tragedy, can be led astray into believing in the non-existent dangers of vaccination.

Vaccination remains a sensible, indeed essential, best practice for the protection of something precious–the lives and health of people we love. Bad information about vaccination puts unvaccinated individuals at risk, but it also harms all of society as we lose the important protection of “herd immunity.”

A recognized best practice also exists in investment management. Diversification is the proven, sensible, documented best practice for managing investment portfolios. All professional investors, charged with managing entire portfolios for individuals or institutions with long-term goals, diversify.

Period. Hard stop. No capable investment professional ever fails to diversify, regardless of the temptations of today’s “hot” speculative opportunity. No sensibly-run college endowment ever puts all its money in one asset class. No foundation decides to bet it all on a single hot stock, fund or manager. No pension plan abandons diversification to go entirely into cash, stocks, venture capital, pork belly futures or Bitcoins.

All of these professional investors recognize that diversification is the key strategy to manage risk and deal with the intrinsic uncertainty of the financial markets. The intellectual foundations for diversification are simply too robust, well-documented, and mathematically compelling to be ignored.

That doesn’t mean institutions never make mistakes. As behavioral finance demonstrates, we humans are all potentially subject to information-processing and decision-making errors. At market extremes, many tend to over-weight the best-performing asset classes, confusing recent price trends with long-term economic advantages. (For a great summary of the thought process that leads investment committees astray, here is a recent piece from the smart folks at GMO, one of the world’s premier asset-allocation firms.)

Despite the abundant evidence in favor of diversification, we’ve recently observed a small number of investors choosing more focused portfolios. They believe they have identified the specific assets that will perform best in the near future–as at prior market highs, usually those assets that have performed best in the recent past. Right now, some smart people are inclined toward investing all of their money in U.S. large-cap stocks, believing that the “Trump trade” will continue to drive domestic stock markets to new highs.

I doubt that any of these folks would consider not vaccinating their children. But they may be in danger of making a tactical blunder with important consequences for the health of their portfolios. We’d hate to see that result.

Be smart. Vaccinate your portfolio. Stay diversified.

J

 

Against the Wind

“Do you want to know how to get rich in the market? Come closer. Close the door. Be greedy when others are fearful. Be fearful when others are greedy.

                                                                                                     Warren Buffett

I’ve written a few times lately about optimism and pessimism, and passed along the observation of one long-term client that the tone of my recent postings has been too negative, so much so that he no longer passes along our material to potential referrals.

I’d like to share a few data points, offer a bit of mild pushback against the accusations of inappropriate pessimism, and then ruminate a bit on one of the paradoxes of investment management.

First data point: The last month saw a reversal of the public’s recent stock buying, with huge flows from stocks to bonds. It is a cliché, no less true for being so-oft repeated, that individual investors always get it wrong, especially at inflection points. After almost five years of market recovery, with the S&P up more than 175% from the March 2009 low, investors began to buy stocks in late 2013. (In other words, they missed a bull market that more than doubled the price of equities.)

The sharp downdraft in January destroyed that emerging confidence, and individual investors stampeded from stocks back into bonds. But they did not exit at the S&P 500’s intra-day market high of 1847 on January 21. They jumped out in time to catch the intra-day low on February 5, when the market was down almost exactly 6%. And thus missed last week’s rally, during which the market gained 3.4%, erasing most of the prior loss.

Second data point: Investors are fleeing emerging markets stocks in droves. As this article makes clear, the last time the investing public turned similarly bearish on EM stocks, in 2002, the next five years saw annual returns on emerging markets of over 30%.

Which gets back to our recent pessimism. The mass of individual investors are at the mercy of their own dysfunctional psychology, getting in and out of the markets at precisely the wrong times. As stewards of our clients’ portfolios, we have two principal jobs:

1) Make, and implement, good investment decisions.

2) Keep our clients from harming themselves by over-reacting to market events.

If we are doing those jobs as well as we possibly can, we will assist our clients in maintaining an even strain, by letting some steam out of the psychological balloon when the markets are over-priced (during bubbles and late in bull markets), and pumping them up with optimism when they are under-priced (during panics and bear markets). Hence our cautious stance over the last year or so.

Here is the paradox. The way for clients to get rich is to behave against the crowd, as Buffett has often observed. Yet the way for an adviser to best attract new clients is to validate their emotions, not to challenge them, especially when those emotions are most excited.

Paradoxically, by doing what is right for existing clients (counseling prudence at market tops, maintaining optimism at market bottoms), we make it harder for our firm to attract new clients. The answer to the perpetual question, “If you’re so smart, why ain’t you rich?” is that being smart makes us periodically unpopular. My own experience is that challenging a client’s emotions can make me persona non grata. I’ve had a few clients over the years whom I kept from selling out in bad markets, and who never forgave me. They ignored the thousands, tens of thousands, hundreds of thousands, even millions of extra dollars they earned by owning stocks during the recovery, but held onto their bitter resentment over my failure to take counsel from their fears. (As one client said, “You just don’t want me to have any feelings.”)

So here is a statement about what sets TGS Financial Advisors apart from most of our peers in the retail advisory space: We are more committed to your long-term financial security than we are to your short-term psychological comfort.

And if you are a friend of the firm, and don’t think we are telling our story very well to prospective clients, consider saying this to the friend, relative or colleague you’d like to send our way:

“My advisor really beat me up to stay invested during the panic back in 2008-2009. I’ve made a lot of money in the market since then. Now he’s telling me to be careful. Did your advisor keep you invested back then? Is he watching out for you now? Maybe you need a second opinion.”

Templeton’s Bull

“Bull markets are born in despair, grow amid skepticism, mature in optimism, and die amid euphoria.”

                                                                                                           Sir John Templeton

My son Jack likes to ask people about Theseus’ boat. It is a classic intellectual puzzle, which explores the nature of being. If an object has continuous presence in the world, but every element of it has been replaced, does it remain the same thing? The question might be phrased as, “Does Theseus’ boat still exist?”

Theseus’ boat was in ancient Athens. I’d like to explore the nature, age, and prospects of a very different thing, namely the bull market.

Sir John Templeton was one of the last century’s greatest investors, often considered the father of international value investing. Way back in 1981, when I was a young stockbroker, an article by Templeton convinced me to buy stocks, at a time when Business Week‘s cover had just announced “The Death of Equities.” I found Templeton to be one of the clearest thinkers and writers about investments, in the same must-read category as are Warren Buffett and Jeremy Grantham today. One of John Templeton’s most famous quotes links investor sentiment with the market cycle: “Bull markets are born in despair, grow amid skepticism, mature in optimism, and die amid euphoria.”

I find this specific Templeton quote of greater value than any other single insight about investing I’ve encountered in my thirty-five years of running other people’s money.  His words provide me with the confidence to buy during market panics, at the same time that many of our peers, and even more individual investors, often lose their nerve and sell.

Understand that TGS Financial Advisors does not make discrete buy and sell decisions based on our assessment of market psychology. All of our portfolio allocations are data-driven, and are based on absolute prices, relative prices, or relative yields. Yet at market inflection points, we have consistently found that the fund flows trigged by our portfolio algorithms are confirmed by our seat-of-the-pants observations of investor sentiment. (Understand that this is a negative confirmation, not a positive one. Panicky investors equals buying opportunity, just as greedy investors is grounds for caution.)

Implicit in Templeton’s wisdom is the eternal disconnect between market psychology and market value; sentiment drives price near-term, but value always trumps long-term. Bull markets proceed from a condition of under-valuation (during the despair phase), through fair valuation (at the transition from skepticism to optimism), and eventually all the way to over-valuation (once sentiment reaches euphoria). As Jeremy Grantham notes, most of the time the market deviates from fair value, though the gap is not always large enough to create profitable investment opportunities.

So what about Templeton’s Bull?  Does he still have room to run? This is a variant of the classic road trip question, “Are we there yet?” Or have we already reached the condition of euphoria that marks the end of the bull market?

My gut reaction is, this bull-market cycle is probably not yet over. Since March 9 of 2009, we have had a 175% bull market run against a backdrop of pretty consistent skepticism. As many observers have commented, this might be the most unloved bull market of all time. Recent investor sentiment qualifies as optimism, though not yet as euphoria. (I’m discounting Jim Cramer, who oscillates between euphoria and despair on a short-term cycle, and is useful only as a reverse barometer, if at all.)

If we haven’t yet reached a state of euphoria, doesn’t this prove the bull market isn’t over yet?

I’m not fully convinced. The emotional landscape of the future must always remain an undiscovered country. Anyone who is married knows the entire impossibility of predicting the future emotional state of a single human being, even that human being we know best in all the world. Predicting the future sentiments of millions of investors is impossible.

One of our best measures of market psychology is our communications with our own clients. At market bottoms, a decent number of clients want to sell out. At market tops, quite a few clients want to chase performance. Not every client, surely, but enough at market extremes to provide a robust contrary indicator.

Recently, we have been raising cash in our portfolios. So far, only one client has called to complain that we aren’t fully invested. We haven’t lost a single client who is seeking greener pastures in more-speculative stocks. This does not seem to me enough push-back for this to be a final bull market top.

Every bull market is different. Sometimes bull markets end, not with a bang, but with a whimper. For example, the 2007 market high was less than euphoric. Will the bull market that began in 2009 end like the 2003-2007 recovery, with risk spreads narrow and stock prices high, or like the great bull market of 1982-2000, with spreads narrow and stock prices utterly insane?

We don’t know, and can’t. So we rely on hard numbers on valuation.

Those hard numbers caused us to be overweight stocks months before the market bottom in March of 2009, a posture that was very profitable for our clients as the market recovered. Today, it is just the opposite. T he numbers cause us to be underweight stocks, and overweight cash. Now as then, we are confident our posture is rational, and guardedly optimistic that markets will prove us right—eventually.