For most of human history, the prevailing belief was that we lived on the single plane of a flat earth. This concept gave order to our belief as to our place in the world and reduced the uncertainty gap in our minds. Only in the last seven hundred or so years did we appreciate that we live on a somewhat spherical planet. Soon after Columbus’s voyages, we came to recognize how we really live in the context of a spinning globe.
In a much less cosmic sense, stock market chart readers have recognized that there are periods — some of them quite long — when prices appear to be within a range bound by repeated highs at roughly the same level and by recurrent lows around the same price levels. Some of these periods can last for years. It was a period of 16 years from the first time the Dow Jones Industrial Average (DJIA) first reached 1000 and to when it decisively broke out on the upside. Depending on what measure you want to use (e.g., the NASDAQ or the Japanese markets), we are still well within these bounded ranges. Normally range-bound markets, particularly those with narrow price ranges, last for a number of months, not decades. We appear to be in a relatively narrow range-bound market, with the DJIA laboring between 16700 and 16000.
There are two important findings after the market either breaks out or breaks down decisively. The first finding is that the amount of time and the aggregate swing from the high point and the low point, is, in theory, added or subtracted to the high point or low point when there is a break-out or breakdown. The second is whether on balance the smart money is accumulating assets from the less intelligent sellers or is distributing assets to the somewhat unsuspecting investing crowd.
Is there a way to successfully predict if we are likely to experience an upside breakout or a downside breakdown? Because my crystal ball is quite cloudy, I am focusing on two aspects that lead to range-bound markets. The first question is whether there is a change in the population of buyers and sellers facing each other in changing market structures. The second question is whether those with smarts and capital are changing their investment policies. It is this second question that the remainder of this post is focused on.
Is it smart to be reducing equity exposure?
The answer, or at least a guide to the answer, may have been foretold last night. At the New Jersey Performing Arts Center there was a showing of the movie classic “Wizard of Oz,” its soundtrack music played beautifully by the New Jersey Symphony Orchestra. For those who are unfamiliar with the film, it turns on the ability of an unseen voice to successfully control a community of happy people. The key to the dreams of the four supplicants seeking special transformative favors was the unplanned revelation that the disembodied voice was an old man behind a curtain who foretold what was going to happen. What occurred to me listening to this magnificent music and watching the film is in today’s financial world the role of the wizard (or in reality, the announcer) is played by the central banks and various media gurus. It is these spokespeople who give investors the courage to invest in an uncertain world.
The question as to whether smart investors are changing their investment policies has a lot to do with the announcers that are speaking, particularly after the curtain has been removed and these experts prove to be humans and not all-knowing and powerful wizards. To some degree, the power of these announcers is based on the flat earth thesis that provided comfort for centuries. This comfort was based on the belief that the leading religious and technological leaders of the day were all knowing. It wasn’t that the few thinkers who did not buy into the flat earth theory were essentially smarter than the established thought leaders, but rather that they started to ask questions that could not be comfortably answered by the established leaders.
Bringing the questions up to date and focusing them on the investment world can be broken down into three sub-questions:
1. Are we so smart or arrogant that we believe we can perfectly understand how the economy and financial markets work and can be controlled?
2. If the supposed leaders are so smart, why are their decisions “data dependent”?
3. Why are the so-called experts’ forecasts so wrong, particularly in the long-term?
The constant revisions to the various time series and the inability to correctly capture relevant information about the “informal” sectors of the economy suggest that data-dependent policies have to be wrong often. In the computer world there is a germane term, “GIGO”: garbage in, garbage out.
There are two other somewhat related and troubling concerns about how the governments and their handmaiden central banks are attempting to manage the round earth’s finances. The first is the use of experimental low interest rates to stimulate the economy. There are at least two long-term problems with this approach. The first is that it makes a mockery of long-term savings, particularly in fixed-income instruments for retirees. Not only are they getting low returns on their hard earned money, but also they are planned victims of induced inflation to counteract the experimental low interest rates.
The second drawback to structural low interest rates is that it exacerbates a sound economic recovery. One of the reasons for the various financial and economic crises that have occurred is that, for the time and price structure, we had excess capacity. The benefit of economic declines is that the excess capacity is withdrawn from the market as supply overwhelms demand. While painful to the workers who have to find new jobs, the removal of these excesses is similar to the way nature handles over-population. The problem with low interest rates is that they remove pricing discipline in making sound investment decisions. Often, new capacity is brought on stream by marginal producers whose supply cannot be profitably absorbed.
One of the reasons given for the low rates and some of the bailouts is that various markets seized up. While that was true for the moment and perhaps it would have been extended for some time, if new markets were not created at reasonable prices, the investments that were shut out of transactions would have been proven not to be adequately priced.
The second tool that is being used increasingly by central banks is to spur on their exports to encourage lowering the value of their currency. As most of the central banks are reading from the same outmoded textbooks, many are entering a global currency war that in the end will worsen their problems and not productively expand their markets.
If you are considering changing investment policies, what should you do?
I agree with Liz Ann Sonders and her associates at Charles Schwab that it is folly to try to time the market. This is particularly true if you share their view of a haltingly rising market. However, in my roles with various investment committees I am very conscious as to the time horizons of many members of these committees. This is exactly why I came up with the time-span portfolios concept.
The place that may need the most attention is the second portfolio, the replenishment portfolio. The purpose of this portfolio is to replenish the disbursed operating needs portfolio. The time span for the typical replenishment portfolio is probably five years. Over this period, two events are likely to happen. The first is a stock market price decline. The depth of the decline is likely to be driven by the speculative force that creates the price peak. The second event is that one or more members of the investment decision-making group will be new to the committee and could be a replacement.
To change even one member of the committee is often a cause for a change in attitude. The replenishment portfolio is a type of balanced fund with at least equity and fixed-income funds in the portfolios. I have been managing most of these portfolios up to the turn of the year with the highest equity commitment that was tolerable. From the beginning of the year through today, we have been redeeming some equity funds to bring the equity commitment to the midpoint of their target range. I suspect that as the market moves higher we will lower the equity proportion to the region of the lowest permitted.
Some changes may be warranted for the third portfolio, which I have named the legacy portfolio (distinct from the truly long-term endowment portfolio) and can tolerate market volatility but doesn’t like it. I do not want to reduce equities to side step a future decline that will happen. I do want to provide some comfort during a period of turmoil. The way I recommend that one should be in both the stock and bond sides upgrades the portfolio holdings. While some speculative positions will do better on the upside, they will fare much worse when the eventual declines occur. Part of the reason for going with high quality is that planned long-term expenditures and surprise needs or opportunities occur and the legacy portfolio may wish to accommodate these opportunities.