Is it Time to Change the Benchmark?

One of the unfair facts of life for investment managers is that our clients insist on two different unofficial benchmarks for performance comparisons. In bear markets, when stock market values are plummeting, clients insist on comparing portfolio returns to cash. However, in bull markets, when stock prices are roaring ahead of other asset classes, clients want to change their benchmark and compare their returns to stocks. There is of course, nothing overly unreasonable about this state of affairs, at least in the eyes of our clients. Unfortunately, if you believe in managing risk by constructing diversified portfolios that own stocks, bonds and cash (and many other asset classes), you are virtually guaranteed to underperform cash in a bear market and underperform stocks in a bull market. This somewhat depressing state of affairs of having your portfolio underperform in both bull and bear market environments is the result of switching between two different benchmarks. We are seeing this unofficial “changing of the guard” with our clients’ perceptions occur now that the market rally is entering its 6th month.

Clients used to ask the question “how am I doin?” in the context of a massive bear market that took the S&P 500 Index down by 57% to its intraday low in early March. The market topped in October of 2007, and for the record it is still about 35% below its all-time high price. If you care to view performance in the context of the market top to current price, then our portfolio results of minus single digits are either very good compared to stocks, or very lousy compared to cash, where investors of all levels of experience can park their money without paying Pinnacle a fee. On the other hand, the stock market has rallied by 51% since the lows on March 9th, and the +25% gains in Pinnacle’s Dynamic Moderate Growth (DMG) portfolios look fantastic compared to cash, and pretty lousy compared to stocks, where investors of all levels of experience can park their money in an S&P 500 Index fund without paying Pinnacle a fee.

We continue to counsel our clients to view investment results over a complete market cycle. Once you take a step back and look at performance in a time horizon that includes both bear markets and bull markets, you can get a good perspective for how we are managing portfolio performance. Depending on time horizon, Pinnacle’s DMG portfolios have delivered between 200 basis points (two percent) and 600 basis points (six percent) of performance over and above our benchmarks, net of fees and transaction costs. This year we are having a phenomenal year relative to cash and a very good year relative to our blended benchmarks. In fact, at the moment most of our portfolios are beating the performance of the S&P 500 Index for the year to date period, which is entirely unexpected in a year where the S&P is delivering positive returns. However, we are trailing from the market bottom, which is entirely expected. So, “how are we doin?” It depends on your investment time horizon and what benchmark you care to use.

We Can We Get Rid of the Parentheses?

My long-time client, Diane, politely interrupted my possibly overly detailed summary of her portfolio returns with the question, “Just tell me when we will get rid of the parentheses?” Parentheses are used in our portfolio reports to separate negative portfolio results, and Diane was hoping we might be getting rid of them soon. She was referring to our trailing 1 year portfolio results, since for the year-to-date period (January 1 to the present) Pinnacle accounts are in robustly positive territory. However, the trailing 12 month returns for Pinnacle Moderate Portfolios remain about 5% in the red? (Note: See your wealth manager for performance numbers for other portfolio policies.) The good news is it appears that history is on our side.

The key to evaluating trailing 12 month returns is to realize that the starting number (12 months ago) changes every day. Unlike year-to-date returns where the January 1 price is always the same, the rolling 12 month return is just as much about what happened last year as it is about current market prices. If the stock market was declining one year ago then, all things remaining equal, 12 month performance is likely to improve as we measure from the lower prices after the decline. And guess what? We are rapidly approaching one of the biggest price declines in history, the stock market panic sell-off that followed the Lehman Brothers bankruptcy on September 17, 2008. So while the current trailing 12 month return for the S&P 500 Index is -20%, if prices were to stay the same the index would break even in terms of 12 month returns on October 7, 2009. Diane, if you own the S&P Index and the price doesn’t change between now and then; the parentheses go away on exactly that date.

The story for Pinnacle Moderate portfolios looks even better. Assuming that current prices don’t change, and considering all of the usual caveats about cash flows, fees, and different portfolio securities due to tax considerations, and considering that this is a completely unofficial, Sunday morning view of the matter, I’m guessing that Pinnacle accounts could break even as early as September 18th, the anniversary of Lehman collapse. Mark your calendars! Of course, there is the not so small matter of current prices, which most assuredly will not stay the same between now and then. Market rallies will take us to positive territory sooner, and sell-offs will postpone the date. Heck, if the stock market rallies 10% on Monday and portfolios gain 5%, we will break even by the time you read this post! All of which is my way of saying that hanging on to short-term performance numbers is best left to Chief Investment Officers with nothing better to do on a Sunday morning.

What Would You Tell a 60-Year Old About to Retire?

A journalist recently asked me this question in an interview. To be honest, I might as well have been asked what the causes were of the Civil War. From the perspective of a trained financial planner and the Chief Investment Officer of a private wealth management firm, the question is, well….difficult. The writer was writing for the Wall Street Journal, and he was looking for some sound investment advice for folks who have been buy and hold, strategic investors for their entire investing life. Now they are faced with the rapidly changing paradigm in the investment community that buying and holding is actually a high risk strategy in expensive markets. As you may have guessed, I flunked the test. My answer wandered all over the place, and I didn’t make it into the article. However, I’ve been thinking about it a lot since then, so let me try again.

Mr. or Mrs. 60-Year Old, don’t spend too much. Americans are used to a certain lifestyle which is apparent in the size of our homes, the amount of traveling we do, our taste in home electronics, our…everything. Spend the money to work with a legitimate financial planner (a Certified Financial Planner, CFP®) and find out what lifestyle you can afford and learn to live within your means. Next, actively manage your portfolio. You can’t afford to buy and hold if the financial markets are going to deliver less than average returns for the next five to ten years. No one can accurately predict the future, but smart people are worried about the amount of debt in the world, and you had better plan for a low return world early in your retirement. Low returns won’t last for the rest of your life, but the portfolio returns you earn early in retirement are disproportionately important to you, so be prepared. Active management can add two or three percent (or more) per year to your returns over time if executed successfully, which could be critical to your success.

If you’ve invested your own money for years and that’s why you’re reading the Wall Street Journal (or fill in the blank financial periodical), you have to invest the time and treasure to become a different kind of investment expert. You can’t be a successful active manager of your money by reading the morning paper and watching CNBC when you come home from work. If you can’t see yourself doing the work, then hire someone to do it for you. Find a professional wealth manager that specializes in building globally diversified, actively managed portfolios. You may have always been a “do it yourselfer” when it comes to investing, but beware. The market is not likely to provide a tailwind to your investment mistakes going forward. You have to know what you are doing in the tough market environment ahead. Good luck.

Here Come the “Tactical Overlays”

The avalanche of press this year about the death of buy and hold investing has surprised even me, and I have been forecasting this change in our industry for just about a decade. Now that financial advisors and professional pension and endowment investors are paying attention, I am watching to see how the industry is going to address this problem. You have an industry that is populated by professionals who have passionately followed the buy and hold dictums of strategic asset allocation for their entire careers, and all of the sudden they need to come up with “the quick fix.” What should they do as pragmatic business people when the status quo about the “right” way to invest has changed, virtually overnight?

When it comes to personal financial advisors, those Certified Financial Planners (CFP®) who are my peers in providing “sophisticated” asset management for affluent investors, I have long predicted that the solution will appear in the form of some kind of technical analysis-driven process. Clearly the least expensive method for active management, in terms of both time and treasure, is to focus on technical trading methods. I can see new institutional level software (i.e., expensive) that will cater to big firms looking to add a “tactical overlay” to their current buy and hold, strategic asset allocation portfolios. In the world of pensions and endowments, my partner, John Hill, recently told me that the consultants to a non-profit board that he sits on recently offered exactly that. The endowment investment committee could remain strategic (buy and hold), or they could purchase the new razzle-dazzle tactical overlay that would change the asset allocation based on their new, proprietary, techno-sizzle methodology. If professional money managers are afraid that their clients are going to demand active management, I think the tactical overlay will be an easy sale.

Of course, the technical solution will not require that the consultant firms that have advised their clients to buy and hold for decades have an actual track record in active management. Or, for RIA’s (Registered Investment Advisors) catering to affluent clients, their new tactical overlay will not require them to actually learn about market fundamentals, do the research, invest in knowledge and people, or be responsible for the asset allocation changes that are integral to active management. They will instantly have a credible, saleable, technologically marvelous, scientific, and relatively cheap, solution to their problem. Since we (Pinnacle Advisory Group, Inc.) are still slogging along reading the research and actually doing the work, a theme that is mentioned several times in my book, I wonder if we somehow got it wrong?

The Oh-So-Sweet Sleep of the Certain

Recently I had the opportunity to review the investment results of two different money managers who had correctly called the market top in 2007 and by January of 2008 had safely invested 100% of their investment capital in cash.  The resulting investment results are, as you can imagine, spectacular.  Both firms are quantitative in nature, meaning that they use proprietary technical-analysis-based methods to determine market trends in order to make their investment calls.  In one case, the manager has a trade-marked trend identification system that protects their clients from downturns.  While I tip my hat to these managers, I continue to view any portfolio construction that is either all-in in terms of stocks and risk assets, or all-out in terms of cash, as a somewhat high risk proposition.

To me, going 100% to cash screams that the investor has 100% conviction that his or her forecast is correct.  I just don’t know how anyone can get to that level of certainty.  I’ve often said that they must sleep the sweet sleep of the certain, with no doubts about their forecast, their trading system, their proprietary models, their decision making process, and the well documented irrationality of their fellow investors.  I’m envious.  When Pinnacle portfolios are positioned to be widely divergent with our benchmarks, as they were in January 2008 with our correct bear market forecast, I don’t sleep well at all.  Experience has taught me that financial markets are notoriously fickle, and that making large bets about market direction…either direction….takes a certain amount of courage, or a certain amount of hubris.  I suppose it is fair to say that we (Pinnacle) are either very wise in recognizing that the irrationality of markets should be approached with the greatest of respect, or we simply lack the courage of our convictions.  I believe that the correct assessment is the former.

From a portfolio construction point of view, it turns out that being fully invested in risk assets still allows a portfolio manager a great deal of latitude to “hide in the market” and still manage risk.  Being 100% in U.S. stocks but owning staples, health care, and utilities is likely to result in capturing 50% of the market’s volatility in a bear market.  If the market rallies and you were wrong in your short-term assessment of market direction, you will still crush cash returns to the upside.  On the other hand, going 100% to cash, when cash pays 1%, is truly a high risk proposition from the standpoint of generating total returns.  There is no “repair strategy” from there that I’m aware of.  Investors must be 100% certain that the market is not about to rally.  For our part, we prefer to actively manage portfolios where our equity exposure varies with our forecasts but we don’t end up at either extreme of market timing.  It allows us to sleep the oh-so-sweet sleep of the uncertain!

The Ongoing Perils of PE Ratios

One of the interesting things about writing a book is that you get feedback from lots of folks about what they liked and disliked the most about your writing.  Recently, someone told me they read and re-read the chapter on P/E (price-to-earnings) ratios (The Incredible, Amazing P/E Ratio) several times and still “didn’t get it.”  It’s not surprising that someone didn’t get it, because clearly the huge majority of investors don’t “get it” either.  If you are a proponent of value investing, and one of the basic tenants of your portfolio construction is to be wary when the market is expensive, then understanding this basic valuation measure is very important.  Unfortunately, as I say in the book, it’s also an ongoing mystery where bulls and bears will look at the same data and reach vastly different conclusions.

At Pinnacle, we look at a wide variety of valuation measures involving earnings and price.  Last week we routinely updated our valuation data and came up with the following P/E measures: (Note: we actually look at more than a dozen earnings-based indicators.)

The current range of P/E’s is fairly wide from a low of 10.83 based on a variation of John Hussman’s price-to-peak earnings methodology, to a high of 18.47 based on a ten-year average of S&P earnings.  Obviously different investors using different methodologies will reach different conclusions from this data.  Even investors who get the same numbers will reach different conclusions.  For example, the 10-Yr normalized GAAP (Generally Accepted Accounting Principals) P/E ratio looks expensive when comparing to the median P/E of around 15 going back to the late 1800’s, but if you exclude the Great Depression and only compare to post WW-II data the median rises to about 17 and the current 18 figure doesn’t look too bad.

The bottom line:  Buy and Hold investors who are looking for a simplistic, quantitative solution to fundamental value investing will be hard pressed to find it.  It turns out that finding value is as much “art” as it is “science.”