At crossroads (again)?

Inflation? deflation? double dip? protracted recession? The directionless markets are symptomatic of a general malaise facing investors who are increasingly at a loss about how best to position their portfolios in an environment where visibility remains poor.

Pundits have been warning for a while that the long term bond rally has truly ended but bond yields have proven otherwise. They have in fact dropped to such an extent that a number of dividend paying stocks have become more attractive investments when compared to their bond counterparts.

The dangers of an uncertain environment is the risk of getting swayed by a particular strategy. Anticipating a double dip scenario, for example, may lead one to structure a more defensive portfolio that is likely to suffer if, instead, a surprise market rally kicks in. Same goes for targeting inflation/deflation strategies. If the opposite scenario materializes, the portfolio will undoubtedly suffer.
So how does one navigate the choppy seas? The most important point is to avoid getting swayed by emotions, especially when market turmoil is the norm. This can be accomplished by defining clear investment guidelines and ensuring that they are followed at all times. Asset classes should have a mid or "neutral" weight with defined bands around which one can tactically maneuver. By sticking to them, we avoid irrational behavior taking hold of our investments.
Markets move in cycles and attempting to time them can be a very dangerous endeavor. Sticking to reasonable guidelines ensures that we avoid the cyclical traps and instead concentrate the portfolio on the more important longer term secular trends that are more likely to ensure that we attain our investment goals.

The Alpha delusion

Does the systematic outperformance of fund managers relative to their benchmark over a long enough period reflect skill or luck? This is a debate that has been raging on ever since the proponents of the efficient market hypothesis entered the scene. If even the weak form of the efficient market hypothesis holds true, most of the outperformance could very well be attributed to just plain luck. The reasoning goes something like this: at a micro level, even if a gifted manager is able to identify industry trends, it is impossible to anticipate powerful random events such as unanticipated changes in government regulation or even natural events. In other words, there is a significant random component that can creep into and distort the earnings of a company.

This isn’t to say that skill doesn't play any role, it certainly does but the danger is that actual skill may be overestimated. Take the following example:
A hundred people are invited into a hall and asked to perform the simple task of flipping a coin. Those that obtain “tails” are kindly asked to leave the hall whilst the remaining persons are asked to repeat the coin flipping exercise. This experiment is continued until one person, the winner, is left. In terms of statistics, the probability of obtaining “heads” is 50%. Each draw is independent from the other, which means that the probability for each draw are not influenced by any other draw. Taking this into consideration, we can expect about 50 persons leaving the hall after the first draw, another 25 after the second and about 12 after the third etc. After about 6 draws there should remain only one person. Now if we forget about this experiment and try to visualize these results in terms of the performance of a particular fund manager, we could easily get carried away into thinking it was due to skill. As the experiment has shown us, the exceptional results could be a result of just plain old luck but the observers are totally blind to this. They are much likely to attribute the way better than average results to the manager's particular skills. That particular manager will be revered and a large amount of money will flow into the fund but if the results were more luck than skill, it will turn out to be a very bad investment.

In the midst of a deflation conundrum...

Sovereign issuer default risk scare apart, the deflationary bears are once again taking center stage as worries grow over the longer term impact of the mountainous debt that governments of the troubled economies have accumulated over a very short time span. If this actually translates into a protracted period of anemic growth, it could trigger a deflationary spiral with real consequences on an already troubled economy. The recent substantial rally in U.S. treasuries are partly symptomatic of this fear. Recall that an out of control deflation causes damage to the economy by shifting longer term expectations for both producers and consumers. As businesses face the prospect of downward spiraling prices they anticipate this by laying off a growing number of workers. Consumers feed into the frenzy by postponing consumption to a future date not only in anticipation of almost certain lower prices but also because of the growing job insecurity as unemployment inflates. All this bodes very badly for stocks which are likely to experience shrinking margins in such a scenario. Same goes for commodities that are a proxy for economic activity. Sovereign debt, on the other hand, tend to shine (which it is already doing) when deflation rears its ugly head as investors flock to it in search for greater security and income that becomes more valuable as prices take a nose dive.

What makes this downturn interesting is that we don't really know how investors are going to behave if real deflation takes hold. Will they be willing to park their hard earned cash into troubled sovereign debt which has lost its traditional "risk free" status or will they go elsewhere? I guess time will tell.

Deep in a crisis...

We are still in a crisis, it doesnt take much to figure that out but it is also most clearly evident when looking at equity market performance figures (see above). If we take the period from the end of July '07 to date, it is striking to note from the graph above that not only the broad equity market index is negative but this is also the case for all sectors (red bars) without exception! I would also add that there is a wide disparity in performances amongst the sectors and that a large number of sectors still have some way to go before they become positive again.

By far, and not surprisingly so, the largest loss comes from the financials sector that is still reeling from the 2008 blowup. It is also interesting to note that materials and energy are in better shape (relatively speaking of course) mainly as a result of the emerging market factor, information technology because of product cycles (firms are replacing their aged computers), and healthcare and consumer staples mainly because these are traditionally defensive sectors that tend to perform well when the economy is limping.

As the economy steadily improves (we expect this process to take some time), growth sectors such as consumer discretionary, IT, Telecom, Energy, Materials and maybe Financials (if they can get their act together) are likely to outperform the rest.

Paul the Oracle...

Now that the World Cup is over, there is growing intrigue on the impressive "psychic" abilities of Paul the Octopus. For those that have no clue what I am referring to, Paul happens to be an octopus that lives in a marine life center in Germany that was summoned by its owners to choose the winners for all seven matches in which the German team participated and the very last match of the World Cup in where he was asked to pick the ultimate winner of the World Cup.
Surprisingly, he was able to pick the winner in every single one of the eight events. I say surprising because from a purely probabilistic perspective, the chances of being 100% correct is pretty low.
With 8 events in total, assuming that each event is completely independent from the other, there is a total of 2^8 (2 to the power of 8) or 256 possible sequences of outcomes. The actual probability of getting it right in all 8 events is in fact 0.5^8 (0.5 to the power of 8) which comes to a total probability of 0.39%! That is incredibly low and to assume that it is purely due to chance is difficult to believe.
So...if Paul truly does have a gift, who knows what his psychic abilities could do to the business of forecasting the markets! Hedge fund managers would finally be able to claim with all honesty that their "black box" strategy is truly a black box, even to them.

Still in troubled waters...

The sheer scale of deficit for a growing number of Euro zone members makes it almost impossible for them to escape the debt trap without going through an eventual restructuring. This is despite the 750 billion Euro collateral put aside for those that may need to tap into it, which in reality serves as a temporary "band aid" to buy some additional time. The governments should not expect to be able to resolve their debt woes by simply becoming more frugal with their spending as a tightening of the belt will have the dangerous side effect of weakening consumption at a time when its needed most. In fact, it is not far fetched to think that belt tightening at this stage could trigger a protracted recession/depression. The G20 summit conclusions are therefore very worrying given that the consensus worry seems to be the risk of a surge in inflation which would mean that they are attaching less importance than would be warranted to the debt driven recession.

As the graph on Greek debt CDS spreads above shows, the problem is far from being resolved, and, in some ways may actually be getting worse.

Seeking growth...

It is hard enough to find investments that can provide capital gains, let alone on a continuous basis, as a growing base of capital continues to chase after limited resources, compressing future expected returns. Although this is an observation that can be generalized, there is growing evidence that emerging economies are in a far more attractive situation both structurally and politically. As property rights in developing nations continue to evolve, so does the wealth and sophistication of its inhabitants which reinforces the economic strength of the countries involved. The future world engine of growth or demand is increasingly coming from emerging economies, in stark contrast to the past when most if not all demand came from western nations. Probably the most damning evidence in favor of emerging markets comes from recent trends in debt to GDP. The graph above says it all, the level of debt in developed markets have exploded. If we combine this with the increasingly ageing populations of the countries involved, the future doesn't bode well at all for developed markets.

Challenging times...

Anxieties are rising as the market turmoil enters a new phase of uncertainty. The palpable market nervousness is understandable because, as blatantly observed in 2008, a sharp rise in volatility translates into a sharp rise in correlations which is the equivalent of modern portfolio theory's worst nightmare as it results in a breakdown of what would otherwise be a robust theory of how to ensure stable returns in an environment of controlled risk over the long term.

The keyword here is "long term" because, thankfully, volatility spikes tend to occur over relatively short periods of time and therefore, it is hoped, cancel out their negative impact over the longer term.

So how does the theory stack up in the real world? Our next newsletter will attempt to answer that question but, in the meantime, the intriguing graph above, known as a "radar" graph, summarizes our thoughts regarding the various asset classes. Reading it is relatively straight forward. Each point in this heptagonal shape refers to an asset class or a sub asset class. Each asset class is given a sentiment score of one to three with one being bearish, two, neutral, and three, bullish. An asset and/or sub asset class with a bearish outlook would be marked at the center of the heptagon whilst one with a bullish outlook would be marked at the outer boundary.