Diversification

60% of a bag full of slow

The stock markets of the world appear to be impervious to every current geopolitical event, including the threat of nuclear terrorism and serial hurricanes, while a growing number of writers are shrieking that the end of the financial world is nigh. (Read the latest apocalyptic broadcast here.) Hmmm. I have my doubts, but there’s a lot of smoke in the air. Conditions being what they are, last week I moved 5% in many clients’ accounts from stocks to short term bonds. That’s very unusual for me. I’ve learned the hard way that even the best-calculated predictive indicators are easily undone by Fed easing. So usually nowadays we simply stay invested. The long-term force is with equities.

However, bonds aren’t deeply attractive right now either, except as a place of relative safety. Some bonds, especially longer-term issues, are overvalued like stocks. And the perception that the Fed Will Make All Things Good is strongly at work in bond-world as well. Here’s an interesting article which details the almost nonexistent difference in three year performance between top-end bond funds. Some of our conservative clients have portfolios which are 60% bonds. Those bonds aren’t producing much. Granted, bonds are traditionally holistically safer than equities, but in terms of gains, they historically don’t do much.

Right now, because of valuations, we temporarily have clients with 60% invested in boring. My hope is to eventually get them into equity bargains, and make some real long term gains. Patience pays.

I think I’ve figured this out.

The more missiles North Korea shoots over Japan without blowing anything up, the more investors think the Federal Reserve is likely to be cautious about raising rates, and thus the more they invest in stock markets.

Absurd but there’s a logic to it.

As someone said earlier this morning as a joke, perhaps the North Korean dictator has a brokerage account or a hedge fund, and he’s doing his part to boost profits. We are only ten or twenty missiles away from Dow 30,000.

We should also consider the consequences if he’s not joking, merely insane. Read some reality here.

Risk Happens Fast

As last night’s 8.2 magnitude earthquake in Mexico illustrates, risk happens fast. We are now conditioned to three beliefs: things will continue as they are today indefinitely, the Federal Reserve will always save us, and we’ll be able to dodge out of the way.

Nine years ago today, that wasn’t the case. One of the largest investment banks, Lehman Brothers, was allowed to go bankrupt and default on its bonds. The stock market fell 25% in one month. The decision to let Lehman Brothers sink beneath the waves was a political choice, based on traditional attitudes towards free capital markets, and one lesson we all learned was that some corporations are “too big to fail.” The global political aftermath of the Lehman Brothers debacle was so painful that it’s doubtful it would happen again.

But the choice to rescue any and all carries risks as well, doesn’t it? We risk rescuing businesses which OUGHT TO FAIL and we reduce the efficiency and effectiveness of the global economy as a result.

It’s worth remembering also that almost nobody was able to dodge out of the way of the Lehman default. Our asset allocations going into the chaos determined our overall performance. As Mark Hulbert and Doug Kass have written, risk happens fast, too fast to dodge out of the way. Diversification has a price, but it also has a benefit.

Read more here.

We send our prayers to those damaged by the earthquake and by Hurricanes Harvey and Irma. It’s a busy world out there.

The stock markets of the world are apparently missile-proof.

Seriously. The North Koreans just shot missiles over Japan and global stock markets shrugged it off.

Yet again we learn why we should stay at least partially invested. In the past few decades, central banks have changed the way investors perceive risk. Most people think now that central banks can rescue us from ANYTHING!

As Hurricane Harvey (yet another non-event in the stock markets) rips its way through Texas and Louisiana, it’s worth pondering what is happening in Houston. Houston is a mega-city. The mayor has said that it’s simply too big to evacuate in the event of a natural disaster. Thus he has advocated sheltering in place…where thousands are flooding. Let’s consider this a lesson in the inevitable imperfection of governments, and support for the concept of financial diversification.

Stay safe.

Read more here.

Are Small Stocks Leaving the Party?

The market for small stocks just turned negative for the year. That’s big news, and you aren’t likely to hear it elsewhere because it disrupts the narrative of a rising stock market.

Why is it happening? This article provides more data to suggest stock market overvaluation. In this case, it’s the small stock markets, exemplified by the Russell 2000 Index. What’s more, this downturn is a divergence: the performance of the Russell 2000 Index is now negative for the year whereas the market for large cap stocks is up. Shades of 2000.

However, this mild decline in the small stock arena, combined with the insecurity created by terrorism in Europe, is likely to trigger a Federal Reserve stall of plans to raise interest rates. So a decline is by no means certain. We simply need to remain aware. Since we are diversified and modestly defensive, if a real downturn DOES occur, we’ll be buyers. When that will actually happen is anyone’s guess.

Good thing we’re diversified.

We haven’t (yet) responded to recent market turbulence by altering our portfolios. We’ve simply been maintaining our current very diversified allocations, which aren’t fully invested in the U.S. stock markets. As I wrote in my last posting, long term holding is a very decent tactic. And right now we’re a little bit allocated towards safety. From this position, it’s OK to ride out short term news.

However, this weekend’s blog on “Wolf Street” is interesting. Read it here.

While we watch financial markets surging today, in an apparent relief rally from not being blown up by North Korea over the weekend, it’s also true that earnings in the S&P 500 are not as good as they seem to be. Quote:

“Aggregate earnings per share (EPS) for the S&P 500 companies on a trailing 12-months basis rose for the second quarter in a row. That’s the foundation of the Wall Street hype. But here’s the thing with these EPS: they’re now back where they had been in… May 2014.”

Thanks to the Fed, the S&P 500 has gone up anyway, and the money we’ve made is real. But good thing we’re diversified.

The Ten Year Anniversary of the day the world changed.

Ten years ago today, French mega-bank BNP Paribas announced it couldn’t place a value on its US-created collateralized debt obligations, complex toxic “derivative” investments, and thus was suspending client withdrawals from the funds which held them.

That was the first indication that the most gigantic financial panic since the Great Depression in 1929 was about to unfold.

The world has changed a lot since then. But many of the same structural flaws remain, patched and propped but not repaired by governments or by central bank intervention. Vastly greater debt loads are even more of a potential problem than they were in 2007.

The greatest lesson of the 2007 Financial Panic was that central banks transformed the investment markets by intervening. Perhaps they helped, perhaps they hurt, perhaps in a variety of ways they did both. But there’s no denying that the central banks are now involved in our financial markets in ways that would have been unthinkable before August 9, 2007.

Another key lesson of the 2007 Financial Panic was that many sophisticated investors did just fine, thank you, while others got hammered.

Yet another lesson was that we all muddle by. If you stayed invested through the carnage of that awful event, you have probably done well, despite it all.

Read more here.

Everyone expects to be a winner (and all children will be above average)

I’m reposting this here from the Heisenberg Report. According to this study, essentially everyone thinks the stock markets will finish higher in one year.

Such a high level of optimism is some kind of record.

My guess is that we got here because EVERYONE expects the central banks to intervene forever. Having painted themselves into this particular social expectation corner, it’s going to be interesting to see what the central banks do next.

Way back in the days of free markets, we were taught that extremes of market consensus are danger zones, and that “the consensus is often wrong”. But as I wrote on August 1st, traditional diversification has been proven unnecessary for so many years that investors could be forgiven for it’s just gonna stay like this forever.

My plan is to stay diversified and keep searching for bargains.

A problem with reality

Is that sometimes it is so irrational. The financial markets are currently radiating “market bubble” and I’m reading a very well written quarterly update by the managers of the Forester Value Fund. It captures all the data which suggests that we are currently at market highs and we are at risk of a coming downturn in both the bond and stock arenas.

But there’s a problem. Forester Value Fund TOTALLY ROCKED our stock market declines in 2000 and 2008. And they also lagged horribly while markets recovered. Why? Probably because they are rational, intelligent, insightful managers who have managed their mutual funds with thoughtful awareness of market indicators. In other words, they’ve done everything courageously, and right. We don’t own the fund now, because we couldn’t lag like that. Instead we’ve used asset allocation mutual funds and international mutual funds to successfully participate at least partially in growing markets.

Yes, Virginia, the financial markets are bat-spam crazy, and many of our politicians are beyond incompetent. But the lower interest rates delivered by central banks have trumped everything else, so markets have continued to rise. By staying diversified and partially invested we’ve accrued a substantial part of the financial markets’ gains. But even as I watch us making good money, I have to shake my head.

Read Forester Value’s superb quarterly update here.

We’re doing great! Now let’s stay cautious.

I’m reviewing clients’ portfolios this afternoon, and given that most of us are relatively conservative I’d say we’re on track for a nice finish for the 2nd quarter. I’m saying this while crossing all digits and holding my breath.

Our international holdings, especially our emerging market holdings, have done great so far this year, which is quite emotionally rewarding since after we bought them last year they laid down like raccoon road kill for some months, and were mostly a drag on our portfolios. Now, however, they have recovered, and more.

Likewise our decision to double down on health care has been rewarding, and our decision to stay in tech has been profitable as well.

However I remain nervous like a cat in a room full of pit bull dogs. As I wrote last week, this has been a very thin market especially domestically. Political risk remains high. Markets are overvalued.

So let’s stay cautious, please.

Read more scary stock market predictions here, hopefully with a small glass of oak-aged rum. Predictions do NOT all come true. However they ARE evidence that we should be careful.

Meanwhile we’ll stay invested and stay diversified. It’s a marathon, not a sprint.