Dear friends,
A number of folks have had questions about Ed's arguments concerning the performance of traditional balanced funds. Being shy and retiring, Ed is not predisposed to post on the board but he does read your comments, often scanning them daily.
Four notes, then, as a sort of gloss on Ed's August essay:
On balanced funds: traditionally balanced funds have provided portfolio protection in falling markets because their two dominant asset classes have had correlations that were, on average, negligible (the one-year correlation over the past century is between 7-10%) and, in times of economic decline, negative (the correlation has been as low as -93%). The Depression, for example, saw consistently strong negative correlations. Cash, at the same time, was not correlated with either. In the past couple decade, the Goldilocks correlation has been positive: both asset classes rose as interest rates fell.
That's been good for investors and helps explain why the Vanguard Balanced Index fund (VBINX) has been nearly unbeatable: dirt cheap, fully invested, religiously rebalanced between two rising asset classes. But correlations tend to be dependent on two factors: beginning valuations and the rate of inflation (hence, of rising interest rates). A combination of pricey assets with rising prices cause stocks and bonds to become positively correlated (as high as 89% correlated), prominently in the inflation wracked '70s. That data is all courtesy of
a 2013 PIMCO study. "This analysis," they conclude, "challenges conventional wisdom for asset allocation."
Ed's argument: all three asset classes might be subject to sharp, sustained declines over, say, the next decade. As a deep value investor, he's pretty much appalled by what he sees as a fundamental disconnect between corporate prospects and stock prices. Bond yields can't go any lower unless you anticipate investor acceptance of negative yield, of the sort Switzerland is getting away with: instead of paying interest, the Swiss government promises to return your principle, minus a modest annual holding fee, in a decade. An article in the August 6 Financial Times heralded the sea change in the nature of bond investing, from "risk-free returns" to "return-free risks." And money market reforms now allow money market funds, often used in mutual fund portfolios, to use variable NAVs; that is, for the first time you might buy a MMF at $1.00/share and see your shares soon priced below that.
It's likely that a balanced fund will still be less-bloodied than a pure equity fund but it still might be surprisingly bloody for years. How many? A balanced fund
could remain underwater for six to eight years if the bond portfolio doesn't offset the declines in the equity portion. The New York Times published
an okay short piece on recovery times, noting that the average recovery time since 1900 for the stock markets has only been about two years, buoyed by dividend yields as high as 14%, but that six to eight year periods can't be discounted.
On 1987 and 2007: the argument is that 2007 initiated a slow-rolling disaster where markets fell, rose, steadied, fell, rose, fell, steadied, fell ... That gave "the smart money" time to reposition to minimize the bloodshed. The market in 1987 rose 44% between January and August, turned choppy for eight weeks, then the crash rolled out over just four trading days in the middle of October: Wednesday (-3.8%), Thursday (-4.2%), Friday (-4.6%) then Black Monday (-22.6%). Markets worldwide fell 40-60%.
Analysts tend to attribute the crash to geopolitical instability (uhhh, Iran was firing Silkworm missiles as U.S.-flagged merchant ships) and computerized trading. "Portfolio insurance" programs, designed to minimize losses by selling fast in the face of a declining market, may have created a negative feedback loop in which each sale triggered a new alarm and another sale. Such algorithms were the province of ultra-sophisticated investors in 1987, today they're common though no one knows
how common since the folks who use them don't necessarily advertise the fact. The highest number I've seen is 84%, a common number is 70% and the most conservative is 50% of all U.S. equity trades.
The question is, does the rise of artificial intelligence and its deployment by the ultra-sophisticated minimize or heighten the prospect of an "oops" on a truly global scale. I suppose if you find the widespread deployment of drone into our airspace reassuring (pretty pictures!), you're also likely to find the widespread deployment of AI in the financial markets reassuring.
As an investment concern, the difference is important: you
can't react to a 1987-style event, you can only endure it or try to find satisfactory ways to permanently hedge your portfolio in advance. Given the doubts, above, concerning a balance strategy and the availability of insured one-year CDs paying 1.25% (with 12-month inflation at just 0.1%), Ed might recommend that you seriously consider the latter.
On paring his portfolio: Ed's wife, from time to time, points out that he has no rational need for 25 mutual funds. I get the impression he sighs, looks at the lot of them, thinks "but he was so promising as a baby!" and then chucks one of them out of the sleigh. I'll let you know if he shares a more-detailed methodology.
On the difference between Ed and me: I'm the taller one, he's more ... uhh, full-figured. Edward used to co-manage a multi-billion dollar mutual fund, I peaked out at mismanaging my multi-thousand dollar 403(b) account. The other difference is that Ed writes
everything that appears under the banner "Edward ex cathedra" while I churn out the fluff and babble. Which I mention just for the sake of folks who are new to the Observer and have misattributed some of Ed's arguments, observations, grumbling and/or brilliance to me.
Back to patching the concrete at the end of my driveway,
David
Comments
"sustained declines" Sounds like a perma bear for the next decade and wonder how long he has had this feeling. Or am I misreading something?? We have seen in the recent past where fund managers have had similar feelings and their funds have seriously lagged over the past many years from holding far too much cash. ARIVX is one of several that come to mind.
Regards,
Ted
Conservative Allocation:
YTD: .55%
1-YR. 1.04%
3-YR. 5.31%
5-YR. 6.09%
Moderate Allocation:
YTD: 1.07%
1-YR. 4.44%
3-YR. 9.69%
5-YR. 9.14%
Aggressive Alocation
YTD: 2.31%
1-YR. 4.64%
3-YR. 4.52%
5-YR. 10.08%
All Equity Portfolio: S&P 500 Index Fund (SPY)
YTD. 2.31%
1YR. 10 61%
3-YR. 16.62%
5-YR. 15.47%
Too, we might need to think about time horizons to define "perma." Is someone who's been deeply skeptical for three or four years "permanently" bearish? And what does saying that say about our own depth of vision? Taken in the context of a forty year career, should we think of four years as "forever"? It was for a lot of the value investors who retired in 1999 and early 2000, worn down by ridicule and the market's ability to generate 200% returns for speculative funds.
This isn't to say that some folks aren't "more cautious than my reading of my facts warrants" or "more risk averse than me." Mostly, I worry when we find it convenient to wrap ourselves in our shawls and move on.
There's a cool and thoughtful piece entitled "The Rhetoric of Hitler's 'Battle,'" written by a famous rhetorician and literary critic, Kenneth Burke. Burke writes: . The "Battle" he's talking about is Mein Kampf, translatable as My Battle or My Struggle.
There are a sort of interesting piece on valuations in the latest Advisor Perspectives. You might recall Grantham's argument that markets don't succumb to bears until their valuations cross the two standard deviation level. He thinks we'll be there around the time of the elevation. The article has some nice visuals on the rhythm of Tobin's Q as a valuation metric.
David
The 'perma-bears' (or bulls) are the ones who repeatedly call for a drop and end up sounding like a broken record for a prolonged period of time .... which, in the 24-hour news cycle of in-your-face "journalism" means someone can come across as a perma-bear after only a few years. To wit: Marc Faber is on CNBC preaching the same thing for years. He may be right *sometime* but being that dogmatic about forecasting -- let alone investing by it -- is a fools' errand. But the one time they're proven right, their track record of early (and thus 'wrong') predictions are totally ignored, because ZMGHEWASRIGHTANDCALLEDIT! What short memories we have, and how uncritical our thinking has become in recent years, eh?
"Can't say more, we've got a commercial break. But coming up next, Pundit X on why this decline is only going to be a temporary correction and it's the perfect time to buy, buy, and buy some more. Stay tuned."
Edit: I do think Ed raised some very valid points/concerns about bonds within balanced funds, though.
All of us to a greater or lesser extent tend to be myopic in viewing markets. (Won''t bore you with a long list of "sure-bets" that later cratered). It's this tendency towards near-sightedness, I think, that Ed's railing against more than anything else.
It's difficult to lower expectations. When I retired at 50-something I was still aggressively invested with high expectations of return. By 70 I'd gradually scaled-back those expectations (kicking, dragging, screaming). Sure - the markets always "come back." It's the requisite time-frame for recovery that makes the difference.
m.kiplinger.com/article/investing/T052-C000-S002-love-stocks-again.html
The thread:
my-engineer-buddy-is-now-crowing-but-we-both-have-smiles
My comment:
Let's keep in mind that what worked in the past for Balance Funds may not work going forward (ala Ed's commentary about balance funds). That's not to say smart balance fund managers (much like Ed) won't find new ways to manage risk and return.
@Old_Skeet portfolio construction always reminds me that asset allocation (ala his sleeves) is often the more important component of a well design portfolio. To me it include three things: Income for present spending, growth for future spending, and portfolio Insurance for the unexpected but very real market risk events.
Income for a young investor is often merely wages, but for a retiree their guaranteed income (pension, social security,etc.) may also need to be augmented with a monthly stream of non-guaranteed income (rent, dividends, etc.). Income pays the bills and retirees often need to design their portfolio to throw off adequate income with a minimum amount of risk.
Growth for the young investor is a very loose term since this could mean an investment over a period of 60 plus years. Growth for a retiree could entail a time frame of 30 plus years. Growth comes with lots of market risk, but often works out over the long term. The periodic downside market volatility combined with human emotions (fear and safety) can derail these important portfolio risk assets in the short term. Designing a portfolio that offsets this market risk requires holding uncorrelated assets. Ed mentioned in his commentary that some of these uncorrelated assets may not perform as well going forward as they historically have.
Trying to meet present and future growth and income needs seems achievable so long as investors stay the course by trying to maximize a balance between risk and return. For me, this means holding adequate uncorrelated risk investments or owning a well managed balance fund.
For over 75 years VWELX has successfully managed risk for its shareholders. I have a feeling this fund (and others) will meet the challenges Ed outlined in his commentary.