March 8th, 2017
By Michael Choniski, Trendhaven Investment Management
“Your assumptions are your windows on the world. Scrub them off every once in a while, or the light won’t come in.” – Isaac Asimov
Our desire for reasoned cause and effect is strong. It has produced a vast collection of theories, ratios, multiples, stochastics, cycles, rules of thumb and elegant calculations in support of an econometric view of financial markets. The assumption is that, once we have certain fundamental business and economic information, it can be used to forecast cash flows that support currently warranted prices for financial assets in markets that are assumed to be rational. Entire industries providing financial products, services and education are based upon the connection between economic fundamentals and market behavior.
More recently, much has been studied and written about the disconnection of economic fundamentals and the behavior of financial markets. This should not come as a surprise if you consider that the connection requires not only a meaningful relationship between fundamentals and market price, but also a consensus projection.
Another school of thought believes that investor sentiment is the real driver of market behavior. The idea that sentiment is a causal factor of future prices may seem to make sense, but the insight escapes me. Unlike economic fundamentals, which might be a leading indicator of price, sentiment seems to be reflective of recent past market moves. So much for sentiment being the driver. Cause or effect, chicken or egg, the study of investor psychology is becoming more popular and will no doubt offer up further observations.
To that end, in his latest work, The Undoing Project, Michael Lewis recounts the decades-old seminal works of Amos Tversky and Daniel Kahneman. The takeaway is that the mind incorporates a variety of biases and flawed heuristics which systematically prevent it from producing the kind of rationality we would like to attribute to our decisions. These imperfections affect the translation of economic fundamentals into opinions about (and sentiment for) financial asset prices. Furthermore, this less-than-rational methodology gets corrupted by the adoption of modern portfolio theory, which in itself contains a range of questionable assumptions and methods.
Recently, there has been an acceleration of interest in using social media to predict trends in investor behavior and thereby enhance predictive power. Maybe someone has achieved this and is putting the insight to profitable effect. But before one agrees to pay a “2 and 20” advisory fee, it’s important to consider that most of the information being gauged is based on the biased evaluations of fundamentals and flawed heuristics from those with the desire to post it on the Internet. Maybe knowing the limits of our ability to predict is more important than the predictions.
The members of my investing micro-community feel more comfortable just looking at prices. Specifically, the prices of financial assets that have shown either strong positive or negative correlation to an asset we want to trade. And by “looking,” we mean observing past price patterns from several different vantage points. For example, it’s important to know that price behavior is different during the topping of a rising trend than it is during the bottoming of a down-trend. Our experience, based on use for 25 years in real-money accounts, is that if you measure the right prices in the proper ways over a long enough history, you can use recent market price data to make real-time investment decisions that produce excellent results. Best of all, we don’t have to deal with the fundamentals that may or may not be driving market behavior, or the mercurial sentiment caused by herd behavior. The price does not have to make sense. We don’t have to like it. It just is what it is, and will be trending up or trending down. CNBC and CNN are turned off. We just watch our analytics and collect a behavior tax from those who employ questionable methods.
We suspect that most investors will continue to own a diversified portfolio of financial assets, largely managed on a “buy-and-hold” basis. If history is a guide, they will keep their nerve and hold on during market declines, only to capitulate from the pain of loss and sell when it seems there is no bottom …. and then return to buy into the topping of a trend, to support the final blow-off. It’s the perfect canvas that enables us to paint a tactical landscape of steady enhanced returns and lower draw-down.
A proven tactical management strategy can be an attractive alternative to traditional diversified passive approaches. One benefit is the avoidance of large draw-downs from which it could take years to recover. This feature of a successful absolute return approach is particularly valuable to pensions, endowments and retirees. Some may have to scrub their assumptions about how markets work in order to see the light.
The prevailing plan of individual investors to be somewhat diversified and to buy and hold seems to make a lot of sense after an 8.5 year run-up in prices of risk assets. But it may be wise to consider how this strategy will serve you going forward. Unless you have a long investment time horizon, you may get caught in the next major market correction at a time when you actually need to use investment funds to pay for expenses.
- It took 17 months for the S&P 500 to fall 57% in the 2007-2008 financial crisis and 5.4 years to recover (total return). More significantly, recovery took that long with central banks flooding markets with liquidity and forcing money out of savings and into risk assets to find a return.
- It took 30 months for the S&P 500 to fall 49% between late March 2000 and early October 2002, and seven years to recover (total return).
It can be difficult to part with an investment that has, over the last 8.5, delivered capital gains and dividends that together have far exceeded the investment returns of investment grade bonds or cash. You hate to be out of the stock market, bond yields are terrible and cash pays next to nothing. And if you get out, how will you know when to reenter? After a 10% correction? After 20%? The answer most often proffered is to just stay invested, ride through any correction, and be in the market when it recovers again, as it always does. Buy and hold and stay the course. This is sound advice if:
- You don’t think the market is ever going to have another major correction (a foolish assumption), or
- The resurgence after correction will be swift and thorough (another foolish assumption); or
- You will not have to use any of these funds when you are in drawdown (which depends on your personal situation); or
- You do not have a good way of knowing when to reenter the market if you get out (which, given the advice available from most sources, is a legitimate concern)
If your plan is to manage risk of investment loss via diversification among a variety of asset classes, how did that work out for you in the last major market correction? Many learned that the price movements of different asset classes can correlate to the downside when you most needed them to be negatively correlated. During the last major market correction, the Fidelity Balanced Fund lost 43% during the same period the S&P 500 tanked 57%.
With negative real interest rates and bloated central bank balance sheets, how much are you willing to risk on your government bailing out market prices when they decline? What rate of return do you expect to realize after you ride through a major correction? The answer to these questions will give you an indication of how long you might have your on-paper wealth in drawdown.
There are alternatives, but they usually will cost more than the handful of basis points your robo-advisor charges. Here is an idea. Consider reallocating into a reliable Absolute Return strategy. Yes, unlike unicorns, they do exist, notwithstanding the lackluster performance of some hedge funds attempting but failing to realize the intent of the strategy. The goal of an Absolute Return approach is to avoid drawdown while delivering a positive rate of return. It is variously attempted mostly with the use of timed market allocations and/or hedged positions. When it works, it will deliver superior and steady long term growth of investment value through market cycles. Find one and you can stay invested in this bull market as long as it makes sense, and have some assurance that you will not bear the full brunt of the next major market correction.
Trendhaven is a registered investment advisory implementing a tactical investment strategy in separately managed client accounts with an absolute return investment goal. www.trendhaven.net.