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2010Jan24 Week In Review

January 24, 2010

WEEK IN REVIEW:
Significant confessions arrived this week from one of the leading proponents of index investing and an icon of the academic community – Ibbotson Associates’ president, Peng Chen. In an interview with Morningstar discussing Modern Portfolio Theory and its dismal 2008 performance in protecting accounts, Mr. Chen said “…we also realized that one of the traditional measures in modern portfolio theory, in particular on the risk side, standard deviation, does not work very well…”
 
Thank you very much, Mr. Chen! It is about time!
 
You may not think you know who Ibbotson Associate is. However, you have probably been in a broker’s or advisor’s office and seen a stock chart showing returns from 1929 with small companies beating large companies beating bonds beating inflation. Or, you have seen a pie chart with an allocation to large, small and foreign stocks mixed with some bonds and cash. Ibbotson is a major provider of the data for what you have seen arguing for fixed allocations, diversification with buy and hold. Risk, supposedly, was “managed.”
 
Not so much.
 
A few years ago, a series of research papers on style box investing were published jointly by ICON Advisors and Tom Howard, PhD of Denver University. They presented and successfully defended in the financial press that style box investing reduces returns by 3% annually! Morningstar, style box inventor, and mutual fund families have huge marketing budgets committed to the “style box mantra,” all to our detriment as investors.
 
Now, Modern Portfolio Theory has been “outed” as not intended to manage market risk. Combined, we must face the markets with a new awareness…a new sense of reality…a “new normal.”
What do we do? As the opening line from The Lone Ranger TV Show said, “Return with us to the days of yesteryear…” Prior to the late 80’s when computers made asset allocations readily available to the financial community, stock market profits were “made the old fashioned way. We earned them.”
 
During the bear market of the 60’s-70’s mutual fund managers were not restricted to large or small, growth or value, US or foreign stocks. They were charged with managing the money, identifying opportunity and managing risk as they understood it. They were not confined to arbitrary academic models. At the end, many mutual fund managers significantly outperformed the DJIA and the S&P500.
 
Profits were earned through hard work watching prices and the flow of money in and out of portfolio holdings. It is true that the market is not predictable. Therefore, using 30 to 70 year averages for portfolio construction is an exercise in futility. Particularly with increasingly dominant high frequency trading, we must shorten our evaluation period to capture current trends, not historic ones.
 
The last few days of this week displayed investor fears over a variety of issues that may impact the future economy and corporate profits. It is all a reaction to headlines which are seldom representative of future market trends.
 
The last quarter of 2009 ended a brief period of investor skepticism. We began this month with the number of stocks in the DJIA, S&P500 and the NYSE with positive trends increasing. At the beginning of the week, the OTC joined the good news pack.
Closing this week clearly exhibited some weakness. However, the selling has not yet changed the market trends to negative. The struggle that banking and Wall Street firms are having is not new. It has been reflected in market prices as early as three months ago.
 
If these struggles are amplified and begin infecting other market segments, the collective prices of global markets will be reflected in the Dynamic Level Asset Allocation model we are now using. It captures daily pricing of Exchange Traded Funds and recalculates asset allocation against cash for capital preservation every day.
 
We did not have access to this data in 2008. We do know that if we had, it would have significantly reduced or completely avoided the October debacle.
 
These struggles may not spill over into lower market prices. Hiring plans by major corporations have increased to the highest level in the MS Business Conditions Index since June 2008. In addition, analysts now expect more positive earnings surprises than negative this year. Further, the quality of earnings is on an upswing.
 
Either way, each day is what it is. If the weather outside is stormy, we must bundle up and change to defend ourselves. If it is warm and comfortable, it is easier to make progress and we will adapt to a different environment. For you boaters, you sail when the wind is at your back. You motor or “row” when forces of nature are against you.
 
Such is our strategy going forward.