The Rules, Part XIII, subpart C

The need for income naturally biases a portfolio long.  It is difficult to earn income without beneficial ownership of an asset – positive carry trades will almost always be net long, absent major distress or dislocation in the markets.  Those who need income to survive must then hope for a bull market.  They cannot live well without one, absent an interest rate spike like the late 70s/early 80s.  But in order to benefit in that scenario, they had to stay short.

More with Less.  Almost all of us want to do more with less.  Save and invest less today, and make up for it by investing more aggressively.  We have been lured by the wrongheaded siren song that those who take more risk earn more on average.  Rather, it is true 1/3rd of the time, and in spectacular ways.  Manias are quite profitable for investors until they pop.

As I have said many times before, the lure of free money brings out the worst in people.  Few people are disposed to say, “On a current earnings yield basis, these investments yield little.  I should invest elsewhere,”  when the price momentum of the investment is high.

I will put it this way: in the intermediate-term, investing is about buying assets that will have good earnings three or so years out relative to the current price.  Whether one is looking at trend following, or buying industries that are currently depressed, that is still the goal.  What good investments will persist?  What seemingly bad investments will snap back?

That might sound odd and nonlinear, but that is how I think about investments.  Look for momentum, and analyze low momentum sectors for evidence of a possible turnaround.  Ignore the middle.

Less with More.  Doesn’t sound so appealing.  I agree.  As a bond manager, I avoided complexity where it was not rewarded.  I was more than willing to read complex prospectuses, but only when conditions offered value.  Away from that, I aimed at simple situations that my team could adequately analyze with little time spent.

That is one reason why I am not sympathetic to those who lost money on CDOs.  We had two prior cycles of losses in CDOs — a small one in the late ’90s, and a moderate one around 2001-2003.  CDOs are inherently weak structures.  That is why they offer considerably more yield relative to similarly rated structured assets.

So, for those buying CDOs backed by real estate assets mid-decade in the 2000s, I say they deserved to lose money.  Not only were they relying on continued growth in real estate prices, but they were reaching for yield in a low yield environment.  Goldman and other investment banks may have facilitated that greed, but the institutional investors happily took down the extra yield.  No one held guns to their heads.  The only question that I would raise is whether they disclosed all material risk factors in their prospectuses.  (Not that most institutional investors read those — they call it “boilerplate.”)

Reaching for yield always has risks, but the penalties are most intense at the top of the cycle, when credit spreads are tight, and the Fed’s loosening cycle is nearing its end.  It is at that point that a good bond manager tosses as much risk as he can overboard without bringing yield so low that his client screams.

Perhaps the client can be educated to accept less yield for a time.  I suspect that is a losing battle most of the time, because budgets are fixed in the short-run, and many clients have long term goals that they are trying to achieve — actuarial funding targets, mortgage payments, college tuition, cost of living in retirement, endowment spending rule goals, implied cost of funds, etc.

That’s why capital preservation is hard to achieve, particularly for those that have fixed commitments that they have to meet.  It is impossible to serve two masters, even if the goals are preserving capital and meeting fixed commitments.  Toss in the idea of beating inflation, and you are pretty much tied in knots — it goes back to my “Forever Fund” problem.

This third subpart ends my comments on this rule.  You’ve no doubt heard the Wall Street maxim, “Bulls make money; Bears make money; Hogs get slaughtered.”  Yield greed is one of the clearest examples of hogs getting slaughtered.  So, when yield spreads are tight (they are tight relative to risk now, but could get tighter), and the Fed nears the end of its loosening cycle (absent a crisis, they are probably not moving until unemployment budges, more’s the pity), be wary for risk.  Preserve capital.

The peak of the cycle may not be for one to three years, or an unimaginable crisis could come next month.  Plan now for what you will do so that you don’t mindlessly react when the next bear market in credit starts.  It will be ugly, with sovereigns likely offering risk as well.  At this point, I wish I could give simple answers for here is what to do.  What I will do is focus on things that are very hard for people to do without, and things that offer inflation protection.  What I will avoid is credit risk.