I am often surprised at how the investment industry media finds ‘news’ in investment methods that Pinnacle has been employing for years. This weekend’s Wall Street Journal offered a wonderful example. In a Saturday article entitled, “Same Returns, Less Risk,” Ben Levisohn and Joe Light describe a new investment strategy where portfolio managers handle risk by targeting portfolio volatility instead of a portfolio’s asset allocation. I found this of great interest because we’ve been utilizing this technique for close to a decade. The article identifies three different methods for targeting volatility. It’s worth reviewing them here and pointing out which of the three is closest to what we do at Pinnacle.
Since the stock market made its recent high on April 2nd (in the S&P 500), there has been a noticeable shift in sector performance. As they often do during periods of market indigestion, defensive sectors such as Health Care, Consumer Staples, and Utilities have been outperforming. Meanwhile, the cyclical sectors of the market that had previously been leading are now underperforming. The notable exception among cyclicals is the Consumer Discretionary sector, which not only continues to outperform the broad market even during this correction, but is the best performing sector this year by a decent margin.
For years, the Social Security Administration has mailed out annual statements to inform you of the benefits you or your loved ones will receive upon your retirement, disability, or death. It has been a great service to have this mailed regularly so that you can stay up to date on what to expect under the three different benefit formulas.
Lately the headlines have focused on Greece and the Eurozone mess, but perhaps it is China that really holds the key to whether the global business cycle will begin to recover in the second half of 2012. A year ago China was fighting inflation and tightening reserves in an effort to take the froth out of the property market and to reverse the commodity inflation that threatened emerging market populations (which are more vulnerable to spikes in food and energy prices then their developed world counterparts). The good news is that last year’s tightening has worked, with year over year inflation dropping steadily. Unfortunately for China, they might have overdone it bit: Growth rates have been dropping at a worrisome pace over the last quarter or so. Many measures of Chinese growth have been decelerating for months, including yesterday’s manufacturing Purchasing Managers Index, which came in below expectations at 48.7. The day also brought news that the nation’s biggest banks are likely to fall short of loan growth for the first time in seven years. The bears are grumbling that China might be caught between a housing collapse and Europe’s recession.
In this year’s Inside the Investment Committee presentation, I explained how consumers of investment management can view the performance of their money manager relative to a performance benchmark. If the benchmark is located on a graph where the vertical axis is return and the horizontal axis measures risk, then the portfolio return can fall into four quadrants relative to the benchmark. If the portfolio is either in the Southwest Quadrant or the Northeast Quadrant relative to the benchmark risk and return, meaning that the manager took less risk to earn lower returns (Southwest Quadrant) or the manager took more risk to earn higher returns (Northeast Quadrant), I label those returns “Intuitive.” This is so because it doesn’t take great skill to simply add cash to a managed account that owns benchmark securities to earn lower returns with less than benchmark risk, and it also takes little skill to borrow money and buy more of the benchmark securities to earn higher returns with greater than benchmark risk.
During our Investment Team meetings, we have been discussing at length our ratchet strategy. According to Dictionary.com, a ratchet can be “a steady progression up or down: the upward ratchet of oil prices.” So, what does a ratchet strategy mean to us?
It’s spring, the birds are chirping, the weather is getting warmer, and for the third year in a row the European worry machine is kicking into full gear. Yes, Spain has been a quiet thorn for most of the year, but it’s somewhat depressing to believe that Greece has resurfaced as the poster child for European political dysfunction. Last year markets worried about disorderly default, and this year they worry about Greece leaving the Euro. Not surprisingly, some recent investment discussions have returned to the Greek crisis, and what it means to world markets and portfolio allocations.
This weekend I had the opportunity to speak to the Baltimore Chapter of the American Association of Individual Investors (AAII). I was pleased to see so many members interested in learning about investment strategy on a Saturday morning. As I always do when discussing tactical asset allocation, I made it clear to the audience that allowing yourself to adjust your portfolio asset allocation based on your view of current risks and opportunities in the market makes perfect sense from a theoretical standpoint (unless you happen to be a Ph.D. in finance, in which case you don’t believe that markets ever deviate from their fair value). After all, if you believe that there are times when assets are undervalued or overvalued, then you should buy and sell appropriately in order to try to earn excess returns. However, while such activity makes sense theoretically, from a purely practical perspective things can get complicated in a hurry. In our experience there’s a surprising percentage of time when our ‘belief’ in market valuation lacks conviction. So, it’s important that your investment process allow you the luxury of claiming that you don’t have a high conviction view of the future direction of the market. At such times, investors need a place to go that constitutes home base. It’s the asset allocation for your portfolio where you have a clear understanding of the potential short-term downside risk of negative returns based on past performance. This “clear understanding” should be reviewed periodically and confirmed by all parties as being a safe allocation in terms of short-term and long-term return and risk expectations. This wonderful place, where everyone can take a deep breath and collect their wits, is called your benchmark allocation.
There are many different ways to go about making projections for prospective returns of the stock market. On one side of the spectrum, at the beginning of each year Wall Street analysts give their projection for the price of the S&P 500 at the end of the upcoming year. Their sophisticated methodology usually consists of applying to the current price a mark-up that conveniently ranges between 8% and 12%. On the other side of the spectrum, financial planners build clients’ portfolios by projecting returns of different asset classes over time frames as long as their clients’ life expectancies. In this case, the very long-term average historical return of each asset class is usually the way to go. Somewhere in between these two extremes lies a methodology grounded in economic theory and valuation and which is used by some prominent portfolio managers (John Hussman and Jeremy Grantham, among others) to project stock market returns over periods of 5-10 years.
I just returned from the Financial Planning Association’s Retreat Conference where I was an invited speaker on the topic of “Investing Outside the Box: Modern Insights Into Portfolio Management.” Now that I’m back in the office, it’s time to catch up on my reading. Here is a review of today’s homework.