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

 

A Tale of Two Kitties

Bill Gross Recently wrote a post about his cat Bob, mourning the loss of a long-time feline companion. Bob followed along wherever Bill went, ever-present, alert and on-guard.

Bandit, one of my two cats, is different. He is a large, black, neutered male. He does not guard anything. Instead, his habit is to lie on the floor right in the middle of the traffic pattern, staring vacantly into space. (Some cats are smart. Not Bandit.)

If you watch Bandit, he seems inactive. Observing his size and girth, you might suspect that his fat has compromised his mobility.

Until he moves. Suddenly, the huge, quiet beast is transformed into a flying ball of fur, a black blur scampering up the stairs chased by the dog, or hurtling around the family room, leaping over furniture and sometimes smashing glassware, in pursuit of our older and smaller cat Millie. (Millicent T. Katt, for those not on a first-name basis.)

Bandit’s apparent inactivity is an illusion. He is simply waiting for his moment, keeping his energy in reserve until some silent alarm goes off in his dim, strange brain, telling him it is time to go. Sometimes I think we should have named him Barkley, after the Round Mound of Rebound who once played for the 76ers. Like Sir Charles, Bandit may look fat, but he has serious hops.

They say pets come to resemble their owners, and vice versa. And maybe not just in appearance.

Bob was quite a lot like his owner Bill Gross, who runs PIMCO, one of the largest bond managers in the world. PIMCO pursues investment advantage within the opportunity set of fixed-income, continuously looking to add a basis point here, two hundredths of a percent there, making the advantages of size, perspective and trade execution gradually accrue returns for their investors.

At our little firm (we run less than one-third of a billion dollars, while PIMCO runs over $2 trillion), we are asset-allocators, like Jeremy Grantham of GMO or Rob Arnott of Research Affiliates. Our advantage is not continuous but episodic. As investors, we spend lots of time sitting and pondering, observing the markets, back-testing different approaches.

But like Bandit, sometimes we move in a hurry. We may react to a threat, when the barking dog of over-valuation chases us partially out of a frothy asset class. (Tech, anyone?) Sometimes we chase the black-and-white cat of investment opportunity, over-loading a cheap asset class in pursuit of gains. Often, we believe our allocation moves may offer both lower risks and higher potential returns.

It is rare when our portfolio adjustments are immediately rewarded. Like the other asset allocators named above, our advantage is usually both delayed and discontinuous. If we buy emerging markets because we think them cheap, it is rare that they begin to out-perform right away. Much more likely is a continued decline.

Sometimes we move quickly, sometimes we wait, and sometimes it is the markets that change fast. But when our results do show up, they are often significant and abrupt. Here is a recent example. For the year ending February 28, U. S. large-cap growth substantially out-performed value, driven in large part by tech stocks:

S&P/Citi Growth: +28.70%

S&P/Citi Value: +21.88%

As you can see, growth had almost a 7% advantage over value. Since we were (as usual) over-weight value, these numbers drove under-performance by the U. S. equity portion of our target portfolio.

But things changed abruptly in March. For the month of March 2014, Large Cap U.S. Growth declined -2.51%, while Large Cap U.S. Value advanced an almost perfectly symmetrical +2.52%, a net swing of 5%. Through last Friday’s close, April saw growth down 3.8% and value down 2.2%. In a bit less than six weeks, a year’s worth of advantage for growth stocks has been reversed.

Of course, any amount of short-term performance surplus or deficit cannot prove a long-term performance advantage or lack thereof. Certainly, I’m not suggesting that these recent numbers demonstrate the likelihood of a continued trend of value out-performance.

What I will observe is that the benefits of asset allocation, when they manifest, often do so significantly and will little prior warning. Let’s enjoy them while they last.

Last Bear Standing?

Over the last few weeks, there has been a steady trickle of headlines about formerly-bearish money managers and commentators who have jumped (or slunk quietly) onto the bull-market bandwagon.

One such is Hugh Hendry, a hedge fund manager who shorted financial stocks in 2008, earning a 31% return in a year when most investors lost big. As is all too usual in the hedge fund space, this made him a rock star, got him lots of exposure, and attracted millions to his fund. Which, somewhat predictably, did nothing much for the next five years, as Hendry maintained his prediction that worse was yet to come. Referencing the possibility of a Greek default in 2010, Hendry commented, “I suggest you panic.”

Last month, Hendry announced that he has now become a trend-follower, and is going long stocks. This after a 160% advance in the markets since the March 2009 low, all of which he missed.

Another perma-bear has been Paul Farrell of MarketWatch, who I singled out as an especially worthless analyst in a prior post. After years of advising individual investors that the game is rigged against them, even predicting the collapse of the capitalist world system and suggesting buying a farm in the mountains and stocking it with canned goods, he suddenly turned bullish in late October. A recent headline tells the story of Farrell’s conversion: 12 get-rich sectors for a hot 2014 bull market.

Of course, Farrell is an idiot. But some of the others advertised as new bulls are not. Of particular interest is Jeremy Grantham of GMO, who we at TGS regard as one of the world’s smartest asset allocators.

Grantham has recently been advertised as a bear-turned-bull, with a Barrons headline pretty typical: Jeremy Grantham’s Bullish Two-Year Outlook. (The Barrons article is behind a paywall, but GMO’s quarterly newsletter, from which Barrons and others conclude Grantham is now a bull, is not.)

Given that Grantham is on our very short list of investors too savvy to ignore, this would be a huge change in viewpoint, and would certainly cause us to question our own cautious investment stance. Even a cursory reading of GMO’s recent newsletter, however, suggests Grantham’s opinion has hardly changed.

GMO’s newletter actually starts with Paul Inker’s analysis, titled Breaking News! U.S. Equity Market Overvalued! Hardly bullish. Grantham then discusses the reasons he believes the U. S. stock market is significantly over-valued, but suspects that irrational investors, emboldened by easy money, are likely to drive it higher before the bubble inevitably pops, finishing the three-time cycle of easy money leading to asset bubble leading to market bust (2000, 2008, and perhaps 2015).

We pretty much entirely agree. This is why we have increased our cash position, and tilted our sector choices so heavily toward managers running lower-volatility portfolios and owning higher-quality stocks.

As John Templeton pointed out, bull markets usually “die amidst euphoria.” We’re not there yet, but we are already past the point where further gains will be based primarily on economic fundamentals. As usual, we remain long stocks, but we are no longer over-weight, as we were from October of 2008 through summer of 2013.