Ed Yardeni is President and Chief Investment Strategist of Yardeni Research. He has been a leading commentator on the economy and financial markets for 25 years, and his daily column has been required reading for Pinnacle analysts for years. Yardeni (at least for the time we’ve been reading him) is known for being generally optimistic about financial markets, which is another way of saying he tends to tilt towards being bullish whenever he can. Dr. Ed wears this on his sleeve, and isn’t at all nervous about letting his readers know that being optimistic is a much better way of viewing the world then the opposite, which tends to be downright depressing. Just last week Yardeni referred to bearish analysts as “nattering nabobs of negativism,” which you may recognize as the famous phrase written by William Safire for Vice President Spiro Agnew to deliver at the 1970 California Republican state convention in San Diego. The full quote, referring to the liberal press, was, “In the United States today, we have more than our share of the nattering nabobs of negativism. They have formed their own 4-H Club… hopeless, hysterical hypochondriacs of history.” Last year I actually wrote to Yardeni to take him to task for similar statements about his optimistic world view, letting him know that we didn’t subscribe to his research because we wanted to read an optimistic assessment of the economy, but because we expected an objective analysis of the facts as he sees them. He wrote back assuring me that he does have a realistic world view, but feels that the pessimistic view of the global economy tends to get more attention than it deserves.
Pinnacle Advisory Group’s Chief Investment Officer Ken Solow looks at the firm’s performance in bear and bull markets. The keynote presentation from our February 25 Inside the Investment Committee event.
The professor who influenced me most at Towson University was Richard E. Vatz, Ph.D., who teaches classes in Persuasion and Advanced Public Speaking. Vatz is a short, wiry guy with a bushy mustache and a wicked sense of humor. Thirty-five years ago, he began his Persuasion class by telling us a story about his best friend, Bob. He described how they grew up in a small town in Pennsylvania, were classmates from elementary school through high school, and after sharing several memorable adventures, were both drafted to go to Viet Nam. After boot camp they were deployed and served in the same unit, where after a year of fairly boring service, just outside of a small, Vietnamese village with a name I can’t remember, Bob stepped on a land mine and died in Vatz’s arms. By the time he finished the story, the entire class (including yours truly) was openly weeping. Vatz then proceeded, with a smug grin, to tell us that he made up the entire tale, and in one of the greatest teachable moments of my young life, asked us why we believed him. After getting over the shock of this deception, we spent the rest of the class discussing how details, numbers, dates, times, names, graphs, etc., all constituted evidence that was very persuasive. We examine this kind of evidence when we determine who and what we believe. Vatz taught me that the speaker who defines the terms of a debate, and who offers the best evidence, is sure to be the winner. It is a lesson I’ll never forget.
This column is called, Echoes from the Pit, not Conversations from the Pit, but I thought you would be enlightened by an actual email string from last week regarding Fed intervention in financial markets. This kind of conversation happens daily as Pinnacle analysts try to reach consensus on how to tactically allocate our strategies. I think you will find the exchange helpful in better understanding how we make investment decisions.
Consumers of investment management might consider three different methods to analyze investment returns. The first method is to look at absolute returns in the context of your financial plan. If the portfolio return was 7% annualized for ten years, was that return high enough for you to achieve your financial goals? What about 3% annualized returns, or 12% annualized returns? Of course, looking through the lens of absolute returns would disqualify negative returns as helping anyone to achieve their goals, so investors often look to other methods to evaluate portfolio returns. Today it is rare to find a manager in any asset class, including hedge funds, who claims to be able to consistently generate absolute returns.
The duration of a bond portfolio tells you how much the price of your bonds will change for each percentage change in interest rates. A high duration means more sensitivity or price volatility as interest rates change. Duration tells you virtually everything you want to know about the price sensitivity of U.S. government bonds, which are presumed to be risk-free from the standpoint of default risk. Prices of government bonds move with a mathematical certainty depending on the coupon and the maturity of the bonds, both of which go into the duration calculation. Investors increase the duration of their portfolio by increasing the maturity of the bonds they own, and shorten the duration by shortening bond maturities. As you move up the risk-of-default scale from government bonds, you can invest in what is known as “spread products,” or bonds that are priced based on the difference, or spread, in their yield to U.S. Treasury securities. Spread products include mortgage bonds, high quality corporate bonds, junk bonds, and emerging market bonds, all of which typically offer investors higher yields in exchange for a higher risk of default. The price of spread products is not only impacted by their duration, but is also greatly affected by investor’s perceptions of the default risk of the underlying bonds. These bonds are priced on their creditworthiness, and are often simply referred to as credit.
Bearish investors look at the chart below and immediately notice that Fed intervention in the form of QE1 and QE2 (quantitative easing program 1 and 2, or perhaps more accurately, money printing programs 1 and 2) occurred after substantial market declines. QE1 is announced after the Lehman Brothers collapse in 2008 and QE2 is hinted at when Bernanke addressed the Jackson Hole conference in the summer of 2010 (after we learned of the Greek debt problems). Given that last week’s news regarding fourth quarter GDP was somewhat disappointing, bears would warn risk takers not to count on the Fed to announce a new QE3 program that would support the equity markets until after the next major stock market correction, or bear market. In addition, the magnitude of the impact of the Fed announcements on the market seems to be diminishing. The market move during QE2 was less than QE1, and the subsequent policy shifts have had less impact than QE2.
In my book, Buy and Hold is Dead (Again), I discuss in some detail Woody Brock’s views on the logical justification for active portfolio management. Brock lays out three ways active managers can outperform. First, they can better forecast structural changes in the economy. Second, they can better forecast how investors will react to changes in the news. And third, they can exploit logical errors of inference (accepted notions about how the markets work that later turn out to be wrong).
Buy and Hold investors tend to view risk as ‘tame’ rather than wild, and often believe it can’t be managed. In this view, risk (defined as volatility) can be measured by a standard bell curve or normal probability distribution, where unexpected events are highly unlikely. Also, market movements are assumed to be completely random, so risk can’t be managed. The best you can do is to diversify your portfolio and wait patiently for historical long-term average returns to materialize (hopefully, before you die).
Visitors to the Investment section of our website — the new home of the Echoes from the PIT blog — will notice that we’ve added an Archive feature to the right hand sidebar. It includes the archive of all our previous posts, going back to May 2009. By my count there are more than 400 articles collected there, organized by month. I thought I would take a quick trip into the Way-Back Machine (a “Rocky & Bullwinkle Show” reference) to see what we we’ve been writing about over the past few years.