Not the Best Day for Financial Planners

Last week I had the privilege of speaking to the Maryland Chapter of the Financial Planning Association about my book, Buy and Hold is Dead (Again).  The results were entirely consistent with my talks to other industry groups about the subject of active management.  There were about 5 advisors in the audience nodding their head in agreement because they already knew what I was talking about, and another 10 advisors nodding their heads because they suspected they knew what I was talking about, and were relieved to hear a speaker say what they had been thinking to themselves.  However, the other 40 or so advisors had the same “deer in the headlights” look that I am used to seeing while they learn that the most cherished assumptions about how they manage money, and how they manage their business and client relationships, are probably wrong.

I don’t envy them their discovery.  To find out that there is very little science behind Modern Portfolio Theory and the Capital Asset Pricing Model is troubling, and then to find out that the Efficient Markets Hypothesis is based on a pricing theory called Rational Expectations, which in turn is based on very troubling assumptions, is bad enough.  But after finding out that most of the Nobel Prize winning gospel that we have clung to for fifty years has been disproved, they next find out that there is no easy answer for how to actively manage money, even if they decided that they wanted to.

Unfortunately, as I say in the book, there is no one correct methodology for determining value, for deciding where we are in the market cycle, or to utilize technical analysis to measure how investors are moving the market.  Instead, my message to the Maryland Chapter of the FPA was that they need to start over, and to learn from the ground up how to develop a forecast and then execute that forecast in a dynamic portfolio construction designed to earn excess returns above market returns.  For them it must have been a terrible afternoon.  After all, Certified Financial Planners are taught that you shouldn’t try to formulate a forecast because forecasts are another term for the hated and reviled act of market timing, and you shouldn’t try to earn excess returns because the markets are assumed to be efficient.  Since market timing (active management) is necessary to earn excess returns, and excess returns are necessary in secular bear markets, it probably wasn’t their best day.

Does the Latest Market Rally Validate Buy and Hold Investing?

Lately I’ve been asked if the latest market rally, a record breaking move of 38% or so over the past few months, validates the idea that investors should just buy and hold stocks.  For the record, there is no market move, either up or down, that validates the idea that valuations don’t matter and investors should blindly own stocks expecting to earn historic average returns regardless of the market’s value when they buy.  However, I thought I would do some “back of the napkin” math to put this rally is some perspective.

If you bought the S&P 500 in March of 1998 and reinvested your dividends you would, as of Friday’s close, have almost exactly broken even on your investment.  The actual price of the index on March 16, 1998 was 1,079.  If you invested in the Vanguard Total Bond Market Index Fund on the same date you would have earned an annual return of 5.57%, very close to the expected returns for bonds if you made the sensible assumption that inflation was going to be 3% for the period.  However, the historic premium for stocks over bonds is about 6%, so if you purchased stocks in March of 1998 with the expectation of buying and holding and earning the historic risk premium, you would expect to earn about 11% per year.

Here’s the bad news.  If the S&P actually earned the 11% that was expected in order to validate the assumptions of buying and holding, the S&P would have to trade to a price of 3,400 tomorrow, a gain of 277%.  If we look at today’s 10-year normalized (average) S&P earnings of $50, the market would have to trade to an unbelievable P/E ratio of 68 at that price.  Or, let’s say you are a raving optimist and think investors would reward the stock market with a multiple of 30 times earnings, a prospect that is doubtful at best.  In such a case, S&P earnings would have to impossibly and immediately grow by 126% to $113.  The recent 38% rally in the stock market does nothing to validate the idea of buy and hold investing, unless we are going to rally an additional 277%.  Notably, the volatility of stocks was five times more than bonds for the period, raising the question of what premium return would have been considered acceptable for investors who ate 5 times more volatility to earn it.

By the way, the next time the market gets to a PE multiple of 30, I will be happy to sell my stocks to the investors who want to buy and hold.

Another Failure for Standard Deviation

Carl Noble, one of our excellent Pinnacle analysts, just passed around a chart from Ned Davis Research showing the short-term standard deviation of the change in price between the Financial SPDR, (ticker XLF), an exchange-traded fund that owns a diversifiedbasket of financial stocks, and the rest of the market as measured by the S&P 500 Index. The chart shows that for the past 44 days the relative outperformance of the XLF versus the broad market has been a 13 standard deviation event. In other words, the odds of this relative price move, using the common measure of risk in the industry, is somewhere around (give or take) once per 6,117,160,000,000,000,000,000,000,000,000,000,000,000 times. That’s a little less than once per trillion trillions. To put it mildly, this price move, as measured by standard deviation, is statistically impossible. Yet here it is, just another failure for using standard deviation as a measure of risk in financial models.

There are two lessons to be learned from the chart. One is that standard deviation can severely understate the probability of events in the world of finance, and investors need to take care when using financial models that use standard deviation to measure risk. Internally, we use standard deviation when we build our risk models that predict portfolio volatility. Externally, we use standard deviation as the measure of risk in the portfolio policy statements signed by our clients, and in the scatter charts we use to demonstrate portfolio performance. In each case, the user must beware. The models communicate a level of certainty about portfolio risk and volatility that can be invalidated by the misbehavior of markets. The past year has reminded us that our caution in using this risk measure is justified.

The second lesson is that after a 13 standard deviation move to the upside, it certainly pays to think about selling. I don’t know if we will ultimately execute the transaction in our managed accounts, but it sure has our attention.

Low Conviction Forecasts

There seems to be a misunderstanding about generating an investment forecast that presumes that active portfolio managers always have a reliable one in their back pocket. Nothing could be further from the truth. Sometimes the forecast is as simple as “I don’t have a strong opinion one way or the other.” Such a forecast actually happens more often than not, and shouldn’t be a cause for alarm for investors. After all, forecasting is all about assessing future probabilities, and sometimes the data simply doesn’t allow for making a high probability forecast.

I believe that now is one of those times. Those that believe that they “know” what the outcome of the current state of economic affairs will be are making a high conviction forecast based on an unprecedented set of economic circumstances. There is nothing new about a country debasing its currency, and there is similarly nothing new about trying to inflate assets in order to prevent a debt liquidation and deflation. But it is certainly new to do so in an economy as deep and diversified as the U.S. economy, and to do so in such a coordinated manner within the global economy. By our count we are now up to about $12 trillion of guarantees and promises to invest by the various agencies of the U.S. government, and that is in the context of a $14 trillion economy. Who can “know” where this will lead?

Low conviction forecasts are not a problem for us as a relative value manager. In this case we get more, rather than less, diversified. In addition, we manage portfolio risk to be closer to our client’s risk benchmarks, as opposed to making large bets one way or the other. Our assessment of whether or not this latest 30% rally off of the intraday low of 666 for the S&P 500 Index represents the beginning of the next cyclical bull is inconclusive. At the moment I would characterize the situation as a coin flip either way, and in that situation we will hug our benchmarks, more or less. However, there is no doubt that the entire investment team would be more comfortable if the market would back and fill a little, and give us the opportunity to add to risk positions after a meaningful retracement of recent gains.

What’s In a Name?

Last October it occurred to me that I needed to come up with a name for my manuscript. The book itself had taken a rather schizophrenic form where the first half of the book was all about investment theory and the second half was a very practical discussion about how to manage money. As I discussed this matter with my editor, test readers, teenage children, and strangers that I met at the mall, it was clear that any title that was too “geeky” was out. What made it through the clutter was a title called, “Buy and Hold is Dead,” which I believe I first heard on CNBC’s Fast Money program. After further discussion, my associate, Michael Kitces, who is the Director of Financial Planning Research at Pinnacle, recommended that we add (AGAIN) to the title. We agreed this more nuanced approach made sense since buy and hold investing dies at the end of every long-term or secular bear market, and there have been at least five of them (depending on how you count them) over the past 100 years or so. Buy and Hold is Dead (AGAIN) passed muster with everyone as a clever and pithy title that would land me on the best seller list, or at least get me on the Jerry Springer show or the Tyra Banks program, both of which are renowned for featuring books about pricing theory and theoretical economics.

Today I happened to Google the term buy and hold is dead, and I’m pleased to report that I only came up with 10,400,000 hits. That’s correct. 10.4 million Internet goers are either writing or reading about buy and hold being dead. Clearly my witty and clever title is no longer as witty as it seemed at the time. So now I’m left to hope that my book stands on its own in offering a different and intelligent view of the financial planning industry, the status quo for professional investing, and the practical approaches to active management that I believe are so important for intelligent investors to understand.

So far Buy and Hold is Dead (AGAIN) will only get you about 6 hits on Google, but I’m hopeful that we can change that number over the next several months. I hope to aggressively spread the message that active money management is a necessity for portfolio managers who want to best manage risk for themselves or their clients. Hopefully I can use this space to comment on this new book adventure as well as the state of the investment industry and the financial markets. I’m unclear how they optimize these things, but this just might be Google hit number 7.