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Absolutely

August 10, 2006 by  


By Bob Wood

Something I’ve mentioned briefly in past columns is the idea of absolute returns. Given that a growing body of opinion agrees that the domestic stock market is entering the next leg down in a secular bear market that began in 2000, this is a good time to revisit ideas about making money in all market environments.

For a brief description of “absolute returns strategies,” find a copy of Alexander Ineichen’s investing book, fittingly called Absolute Return. His clear explanation of absolute returns includes the following:

“The absolute return manager invests in the full range of investment opportunities whereas the relative return manager does not. An absolute return manager, for example, can hedge unwanted risk, can change risk profile by levering and de-levering according to changes in opportunity set, can exploit inefficiencies on the short side, or can explore valuation differences among equal or similar financial instruments.

For a skilled asset manager, a greater pool of investment opportunities leads to greater performance. There are also differences in terms of magnitude of the investment opportunities in addition to differences in the opportunity set. If a relative return manager has a large cap U.S. equity market index as an investment benchmark, he or she is forced to exploit inefficiencies in one of the most efficient financial markets in the world. The magnitude of mispricing is unlikely to be large and the cost of finding the inefficiency prohibitively high.”

What he means by the term “relative return,” of course, is simply what most brokers and money managers strive for—outperforming “the market” or other benchmark. This effort supports the interests of proving that active management surpasses indexing. A large cap fund manager who beats the S&P 500, for instance, thereby “proves” his value over a passive index fund and can take his annual fee without embarrassment. But even managers who fail to outperform index funds seem to take their fees embarrassment-free, don’t they?

Over time, the truly rare active manager should show real value when compared to a passive benchmark, particularly one resembling the portfolio of stocks chosen by the manager. But considering the current market environment, one can easily argue that attempting to beat an index like the S&P 500 may be futile, even though some managers succeed in doing so.

The problem now is that we are most likely approaching what is called ‘‘the next leg down,’’—resumption of the secular bear market, which began in 2000. If this is true, and I believe it is, what is the value in beating a stock market index destined to lose ground over the intermediate term of maybe five to 10 years?

Many will attempt to outsmart one index like the S&P by diversifying into small- and mid-caps and, perhaps, adding some international exposure. But indices exist for those areas, too. So, since most of the allocation will probably center on domestic markets where various indices may well fall, what is the benefit of trying to beat those markers?

Diversification and asset allocation methods of investing were developed in their present form in the 1950s when domestic stocks and bonds were the two asset classes of choice. Since demographic and economic growth were strong then, nothing more was needed. But times have changed, and the onset of a bear market when a worker enters his prime savings years can make a manager who beats the benchmark seem worthless.

But changing times call for new ideas. The ideas supporting absolute return investing have been in existence just as long as asset allocation and the Modern Portfolio Theory. The theory developed by Alfred Winslow Jones in 1949 offers advanced thinking about getting a solid, risk-adjusted return, regardless of whether the market rises or falls. And it can be done!

As Ineichen says in the quote above, the idea of ‘‘levering or de-levering’’ is one simple tactic that anyone can use safely. Here, the term levering refers to adding portfolio risk using margin debt during bull markets and adding cash after reducing stock allocations in a bear phase. Investors today can do this right from their home computers by selling some stocks and holding onto the cash.

For many of you, though, another of the better tactics may not be a good option—for philosophical reasons. Selling stocks short, based on the belief that they are over-valued, is one that I use rather liberally in my model accounts, though it is not for everyone. By the end of July, these accounts were showing gains of 18 and 20%, year-to-date. A fair amount of this gain has come from successful short sales. After all, in a falling market, most stocks will lose value, though some will win. Short sellers live for falling markets!

To quote a guy who would have been a great investor, Mr. Spock from the “Star Trek” series said, ‘‘There are always options.’’ And while I never watched the movies, I do remember noting how calmly analytical his character seemed to be, and I use that approach in my own daily work.

There are always options to consider. If you aren’t comfortable with shorting stocks—and I hope that none of you are, regardless of your beliefs, as it is a rough game to play – consider bear market mutual funds, which I have covered in previous columns. And now, other asset classes, that weren’t part of the consideration process when hedging, absolute investing and asset allocation methods were first developed, are available now.

Simply consider the use of alternate asset classes, those that are under-valued, not on a relative basis with the expensive domestic stock and bond markets, but on an absolute basis. Some of my current favorites include international and emerging markets, as mentioned before in this column.

Some examples include markets where most would feel comfortable investing only small amounts—if any at all. For example, I see in a table in the daily edition of the Financial Times newspaper showing the Brazilian market selling at about 12 times earnings with the local economy looking quite strong. Another new find is the market in Thailand, even though the country is embroiled in a government crisis of sorts. But its market is selling at about 8 times earnings, and internal issues will, at some point, become more settled.

Asian markets also are priced much better that our domestic markets, and where do economic fundamentals look healthier than there? Follow the money and job creation, and you will find viable markets for allocating small amounts of your portfolio.

The energy markets seem to offer another great investment option, since the most profitable companies on the planet are selling at single digit multiples while the crowd still trades tens of millions of shares daily in losers like Lucent, JDS Uniphase or Oracle. And the energy corner of the stock market is enjoying global demand that previously seemed impossible. World demand for energy is on pace to grow far faster than supply for the foreseeable future.

The idea behind investing is to make money, of course, but what if the domestic stock market represents more risk than return potential? Do we ride along for as long as it takes, hoping that the “stocks for the long run” nonsense repeats simply because it did in the past? What if the wait for a real secular bull market in the U.S. takes another 10 or 20 years? And I think it will!

Are there no better options? I think there certainly are—and enough of them to go around, since the crowd is always so late in finding the best asset classes and markets for investing. And it seems foreign to many domestic investors that beating this or that index is not the path to investing success. For me, only one benchmark is worth beating, and that is the number zero!

Making money is good, and compounding returns is the only way to make money in risky assets. Losing even small amounts over extended periods of time equals investing defeat, and the long, secular bear markets in the U.S. during the past 100 years have proved that they were too damaging to ever allow recovery, in real and absolute terms. My best advice might be to avoid expensive markets like the S&P 500 or the Dow altogether and find opportunity sets that show value.

Have a great week,
Bob
Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., bwood44@tampabay.rr.com.

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