From the 2002 bottom until the 2007 market top it was hard to go wrong no matter what you did. Everything from junk bonds to commodities to emerging markets to the major market indices were all headed up. This made people feel they were protected from harm. It was an illusion.
Here is an interesting email from Steve who describes his experiences at attempting to beat the averages during this period.
I used a fee-only financial planner to evaluate our portfolio of mutual funds using a Monte Carlo analysis tool to estimate how much we needed to save annually to hit our retirement “number.”
I’ve been a premium Morningstar member for years and I’ve tried to assemble the best group of boutique funds to cover every area of the investment landscape. I used a matrix with 3 columns for Growth, Blend, and Value with 5 rows for Large Cap, Mid, Small, Micro, and International funds.
We held 15 funds including all the best Morningstar performers for many years like Primecap (VPMCX), Dodge & Cox (DODFX), Longleaf (LLSCX), Artisan (ARTVX), etc.
All of those funds performed better than the market, but not by much after all taxes and fees are subtracted. To be perfectly frank, it pisses me off that I meticulously chose and invested in the absolute best mutual funds on the planet and the BEST that they could do in 2008 is lose 35% instead of the 38.5% the S&P; 500 lost!
It’s amazing how limited they are by not shorting, being hesitant to hold large amounts of cash, and having to sell at the wrong times due to redemptions. Let’s face it, I truly gave it my best shot and it just wasn’t good enough.
It was an interesting exercise, but all I did was outperform the S&P; 500 by a few points over a 14 year period.
Diversification Isn’t a Savior
Steve followed the conventional wisdom of asset allocation: buy some mid caps, small caps, big caps, foreign equities, etc. Steve proved beyond a shadow of a doubt that diversification is not a savior, not even if one meticulously selects the best of breed.
What Went Wrong?
Diversification obviously did not help because everything Steve invested in was positively correlated to the major market indices. When times are good, such strategies make people feel like geniuses. Bear markets always have a way of exposing the flaws.
On an individual basis, the sad reality is most funds simply want to beat their target benchmark. To do that they frequently feel they must be fully invested 100% of the time. Then by throwing out a few obvious dogs and overweighting a few top performers, managers can beat their target.
Why Fund Managers Are Reluctant To Hold Cash
Steve mentioned mutual funds are unwilling to hold cash. The reason is many fund managers are always in fear of missing a rally and many do not get paid when they are sitting on cash.
To reiterate something I noted in Buy and Hold is Still Bad Advice:
In January of this year, an investment advisor from Wachovia Securities called me up and stated “Mish, I am sitting on millions because I see nothing I like”. I told the person I did not like much either and that Sitka Pacific was heavily in cash and or hedged. His response was “Well, I do not get paid anything if my clients are sitting in cash”.
I called up a rep at Merrill Lynch and he said the same thing, that reps for Merrill Lynch do not get paid if their clients are sitting in cash.
By the way, that person at Wachovia Securities did the right thing and sat on that cash.
Massive Conflict of Interest
Notice the massive conflict of interest possibilities. Reps for various broker dealers have a vested interest in keeping clients 100% invested 100% of the time, even if they know it is wrong. And so it is every recession, bad advice permeates the airwaves and internet “Stay The Course”.
No Gains For 12 Years!
Steve noted his “best of the best” diversification strategy beat the market by a few percent. Unfortunately, on an absolute Return basis, -35% is a horrible year no matter what the benchmark is. Note that the -38.5% decline in the S&P; wiped out all gains for the last 12 years.
click on chart for sharper image.
Off To The Races?
People are expecting it’s off to the races again with the rally since May. Not so fast.
Fundamentally the market is very overvalued here. Expected earnings growth is unlikely to happen for many reasons. Clearly that does not preclude a further rally, but the above chart shows what happens to market rallies based on speculation as opposed to fundamentals.
Perhaps the market has bottomed, but perhaps it hasn’t. Even if it has bottomed, where is it going? Consumers are 70% of the economy and consumer attitudes toward debt, consumption, and risk taking reached a secular peak. Moreover unemployment is still rising and consumer balance sheets are in shambles.
On November 16, 2008 in Peak Earnings I wrote:
Financial earnings have peaked. And because of reduced leverage, earnings in the financial sector are not coming back for decades. Those earnings were all a mirage in the first place. (Take a look at the charts for BAC, C, WFC, or JPM. Charts for Wachovia, Washington Mutual, Countrywide, Lehman aren’t available for a reason.)
Next consider homebuilders given that lending standards have dramatically tightened at banks. Those profits are never coming back.
One must also factor into the earnings equation boomers facing retirement in the wake of falling home prices and retirement accounts taking a cliff dive. Trillions in potential spending power has been wiped off the books.
Expect boomers to travel less than expected, buy fewer toys (boats, cars etc) than expected, gamble less than expected, and downsize much more than expected in every aspect. This in turn will reduce the earnings potential of non-financial corporations for decades to come. Thus expectations that a new rip roaring bull market will commence once the market bottoms is sadly misplaced.
This secular bear market will last a lot longer and be much deeper than anyone thinks. Sadly, very few are prepared for it.
Japan had two lost decades. Might not the US lose two decades as well?
$NIKK – Nikkei Monthly Chart
The Japanese Stock Market is about 25% of what it was close to 20 years ago! Yes, I know, the US is not Japan, that deflation can’t happen here, etc, etc. Of course deflation did happen here, so the question now is how long it lasts. Even if it does not last long, there are no guarantees the stock market stages a significant recovery.
Buy-and-hold is no more likely to be a good choice for the next 5 years than it was for the last 20.
Pension Plans In Serious Trouble
Even in a sideways market, the already seriously underfunded pension plans and annuities will eventually become bankrupt. Yet, a sideways market is about the best I think we can realistically hope for.
Pension plan assumptions are simply way too high.
Correlations Still Ugly
And what if the bottom is not in? The sad fact is once again we are seeing the same type of correlations we saw in the markets in 2008 where all asset classes rose or sunk in unison.
Please consider the July Sitka Pacific Monthly Newsletter:
From the hopelessness we saw in February and March, the vast majority of investors suddenly became convinced that the bear market was over that the economy was moving towards recovery. Such rapid sentiment shifts from pessimism to optimism almost never occur at significant market bottoms, and so we were left with what increasingly looked like a standard (but large) bear market rally in its later stages.
It appears we saw the end of that rally in June, and that was the case for most global stock markets as well. And not only stock markets, but many commodities reached a high in June and then turned down, as did many other asset classes. To say all these markets have been correlated is an understatement—moving in lock-step is a more accurate description.
The two charts below are but two examples of these correlations. On the left is the MSCI Emerging Markets index, and on the right is the Nasdaq Composite.
click on chart for sharper image
1. Since a new bull market in not sight, it’s important to continue to view stocks as vehicles for trading, not for investment. There will likely be many ups and downs, and stocks could remain relatively range bound for an extended time. We will attempt to stay hedged during most of the declines and open to market fluctuations during most of the advances. However, the key will be to remain uncorrelated to the markets overall.
2. The correlation among markets over the past two years largely reflects the ongoing deleveraging process. Until this dynamic changes, the Modern Portfolio Theory method of managing risk by diversifying among many asset classes and geographic regions will remain prone to the kind of severe draw downs seen in these strategies in 2008.
Looking ahead, one still needs to trade, hedge, or pick strategies that are uncorrelated to the markets. There is simply no reason to expect a buy-and-hold shotgun approach of picking best of breed mutual funds will perform better for the next 5 years than the strategy did for the last 12.
Mike “Mish” Shedlock
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