A reader sent me the following question:

Hi David, this is shall be link to your impossible dream part 2 question.

You mention in the article date May13 that we are probably at #4 part of cycle (looking back great called) Where are we in the part of the cycle? ( I would assume we are in #5) if that is the cast..why you added large 5 of your cash in this sell off? (for trading or for investing) Hope I am not asking too much since I am not a client, only long time reader whom respect your opinion.

Here’s the article he was referencing.  There is a tension between my equity management and the switching strategy I proposed in the first Impossible Dream question.  If we are in a market where we should be allocating asset to safe areas, why am I buying more equities here?

It’s a question of time horizon.  The switch model tells you what will do well for the next month.  I am playing for longer horizons.  That’s why I have my seventh portfolio rule:

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

My best purchases occur in bear markets.  I buy things that are safe but way out of favor, and they rocket back when the market finally turns.  That adds a lot to my alpha, which is more than the advantage of switching, historically.  That’s why I average down in bear markets, if the thesis behind the investments is still valid.

As for what phase we are in, I would say 5 or 6. Cycles aren’t neat.  In this case, we don’t have a lot of defaults, but we do have a lot of negative momentum in equities. In four months we have moved from top momentum, top valuation, to bottom momentum middling valu1ation.  That is pretty deep in the don’t buy stocks region, but it often offers the best opportunities to long only investors, if one is buying for three years, rather than one-to-six months.

So I continue to buy equities that are attractive, even in a market where bonds might be favored in the short run.  As for my clients, it is a question of investment horizon.  Short-term: bond strategy.  Long-term: equity strategy.

In general, I aim for the long term.

Many fundamental investors have been shaped by Peter Lynch.  Invest from the bottom up.  Analyze companies, not the economy. Time spent on analyzing the economy is wasted time.

This book takes the opposite approach.  If you understand the economy, and think you know how GDP growth and inflation will go, you have a better chance of choosing the right industries and outperforming.

Like my methods of investing, he looks to understand where we are in the business cycle.  After that, look for good companies that exploit the tailwind.

I became familiar with the main author in the mid-2000s, when he worked for ISI Group.  I appreciated his approach to the markets, which was similar to mine, as the bubble grew, and he and I warned about it.

Think of it this way.  If you had been reading the main author in mid-2006, and had listened to him, how much better off would you be now?  Considerably better off and I offer many warnings over at RealMoney.com before the crisis emerged.

The book will help you understand the sectors and factors in the market that affect returns, and what elements lead those returns.

Beyond that the book expresses skepticism over many of the current economic policies of the US and other governments amid the overindebtedness of much of the world.

At the end, rather than saying, “This is what you should do,” the book asks what your views are, and says if you believe in “such and so” as an economic future, this is what you ought to do.

I liked the book a lot.  I think it is of value to most fundamental investors.

Quibbles

None

Who would benefit from this book: Most fundamental investors could benefit from this book.  If you want to, you can buy it here: The Era of Uncertainty: Global Investment Strategies for Inflation, Deflation, and the Middle Ground.

Full disclosure: The publisher sent me a copy of the book for free.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

How do we estimate what returns are reasonable to expect?  Most investment counselors fall back on easy rules of thumb, but is there a way of doing better?

In this book, the author takes academic research on investment returns, and tries to make it practical.  What are the main findings of the book?

• Momentum works.
• Value works.
• Illiquid assets can work very well if you have a balance sheet that can hold them.
• Carry strategies work most of the time, but when they fail, they fail big.  Same for strategies that sell volatility.

The book does a very good job in establishing that the excess returns of stocks over bonds are a lot lower than most believe.  It also supports the idea that moderate risk taking is the superior strategy.  Those that take high risks lose too often.  Those who take no risk don’t make anything significant.  Moderate risk-taking is the sweet spot.

One of the strengths of the book is that it considers almost all assets, and analyzes how many factors affect those asset classes.  The book is comprehensive; it covers everything, even if it is only an inch deep in spots.

I liked this book a lot, but it’s not for everyone.  You won’t find a lot of difficult math here, but you will find a lot of numbers.

Quibbles

I don’t agree with the idea of levering up low risk assets.  Yes, if you are  the only one doing it, fine, be a non-regulated pseudo-bank.  The trouble comes when many do it.  Eventually a liquidity crisis hits, and those levering up low risk assets get hosed.

The same is true of university endowments.  Too many thought it was easy money to invest in illiquid assets, and when the liquidity panic came in 2008-2009, they were forced to borrow, and/or sell illiquid assets at an inopportune time.

The book does cover everything, but it doesn’t cover everything deeply.  I think it is a valuable book to most who do asset allocation, but the author knows his limits, and does not claim to be expert in a number of areas.

Who would benefit from this book: Fundamental investors who want to understand the factors behind return generation can benefit from this book.  If you want to, you can buy it here: Expected Returns: An Investor’s Guide to Harvesting Market Rewards (The Wiley Finance Series).

Full disclosure: The publisher sent me a copy of the book for free.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

I consider myself a lesser light compared to many following Warren Buffett.  Yes, I am a value investor and an actuary, so I guess I have some punch in attempting to analyze the actions of one far greater than me.

The book is organized around two main trips that the author made to the Annual Meeting of Berkshire Hathaway, with some notes from the the 2011 tacked on.

This book tries to distill the ideas of Buffett into simple concepts, and largely succeeds.  It also alleges weaknesses  in Buffett’s reasoning.  Why not consolidate similar, less profitable businesses?  Why not invest a little more in existing businesses? I partially agree: I used to call Berkshire Hathaway “a grab bag of undermanaged businesses.”  But I’ve changed my mind, mostly.

The cost of doing the first of those could be considerable.  Buffett gets certain deals because the seller knows that he will leave the business alone.  The unique culture, friendships, family relationships will be maintained.  The seller doesn’t get top dollar, but he gets the satisfaction that he was true to those he worked with and served him.  Getting these businesses cheaply is a competitive advantage for Berkshire Hathaway, even if it means a certain amount of inefficiency.  Personally, I expect the next CEO or two will centralize the company, and turn it into a normal company.

As for investing more in existing businesses, all the manager has to do is put forth the case to his boss, Buffett.  Buffett will give him a quick decision.

But the author is right, in general, Buffett has not focused on organic growth.  He has acquired all of the businesses that the owns, aside from the reinsurance business.

This book has many strengths:

• It recognizes that there is a cult following around Buffett.  He’s a bright guy, no doubt, but few questions get asked him by shareholders about his main duty, that of being CEO of Berkshire Hathaway.
• It points out the significance of Charlie Munger, who got Buffett to think more broadly about value, served as a “Dr. No” to Buffett’s more optimistic demeanor.
• It doesn’t spend a lot of time on Buffett as an investor in public equities, which has contributed much less to the growth of Berkshire than the acquisition of whole companies.
• The demographics of Berkshire’s Annual Meeting are older and white, and in general, are the patient shareholders that Buffett likes.
• Omaha is an unusual place for such a large company, but the isolation is a plus if you are trying to do something different.
• Understands the basic safety rules of Buffett’s investing: margin of safety, patience, think like a businessman, simplicity, read a lot, be a good judge of character, think independently, get the big ideas right, the value of cash, don’t risk the firm, etc.
• Notes the value of ethics at Berkshire, even when significant mistakes are made, like the handling of the David Sokol incident.  Reputation matters; you only get one reputation, and it affects all aspects of your business.

Quibbles

• Berkshire is primarily an insurance company.  I would have spent more time on that.
• I would have spent less time on non-business ethical issues, like abortion, religion, etc.  Buffett is no good guide there; he is merely justifying his past actions.
• The bit about the Hoopa Indians was interesting, but when Buffett said, “I agree that we will not exercise decisions except those ministerial in nature,” he was being very clear and simple.  Buffett is not a Christian, but he was raised in a Presbyterian household.  A minister is one who does things on behalf of another.  The issue is that there are 4 California hydroelectric plants that are old.  If the Federal government destroys them, it may help in salmon production, or farmers might like the extra water for their own use.  Buffett will simply do what the authorities want done if they are willing to pay to do it.  It is not his call in a regulated industry.
• Buffett’s hypocrisy on taxation is not addressed.  He backs high estate taxes and high personal income taxes, but he doesn’t pay those.  The increase in his wealth though Berkshire, which does not pay a dividend is sheltered from tax, because he never sells a share.

Who would benefit from this book: Anyone who wants to invest better could benefit from it. At five bucks, it’s cheap. A Kindle application for my laptop was free with the purchase.  If you want to, you can buy it here: Secrets in Plain Sight: Business & Investing Secrets of Warren Buffett, 2011 Edition (eBooks on Investing Series).

Full disclosure: I bought the e-book with my own money.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

This post is for average 401(k) investors.  I’m going to let you in on a secret that is not so secret, but does not get talked about much.  It’s a simple idea as well, and would be common sense, if sense were common.

401(k) investors tend not to change their allocations often, except to panic when things are going bad, or arrive late in bull market, and buy near the top.  In general, if you don’t have a lot of investment knowledge, it is good to come to a place where you “set it, and forget it.”  Remember, those with no experience are far more prone to the errors of fear and greed than most experts are.  Those arrive late to a rise or a fall in the market, and say, “Look what I have missed out on,” or ‘Look at how much I have lost,” are going to make the wrong move again and again.

There are temptations as an investor to not diversify.

• “I’ll just hold all my assets in a money market fund.  I don’t want to lose anything.”  Money market funds preserve value at best.  They won’t help you build value.
• “I’ll just hold all my assets in gold.  I don’t want to lose anything.”  Gold preserves value at best.  It won’t help you build value.
• “This manager is the greatest.  I’m putting it all on him.”   Sadly, managers have hot and cold streaks.  Many people join in near the end of hot streaks.  The quote I heard this from was a professional in 1999, deciding to invest all his money with Bill Miller.  Bad timing.
• “Stocks win in the long run.  I am investing only in stocks.”  If you have a really long time horizon, and you are certain that your nation will not go through a revolution, or something close to it, that will work.  Otherwise, you are taking a risk.

There are more, but I think you get the point.  In most of life, those who do the best are the ones that take prudent risks.  Prudent risks are where the likely rewards outweighs the likely risks.

Think of it: in business, the guy who never takes risk does not do well.  The guy who takes huge risks blows up frequently, and does not do well on average.  The guy who takes moderate, prudent risks tends to do well.

The same is true of bond investing.  Those who invest in bonds of medium risk (BBB/Baa) tend to do best, those that play it safe or risk it all do less well.

The same is true of stock investing.  Stock investing is risky by nature, and in general, those who take less risk tend to earn better returns over time.  Ignore the canard: more risk, more return.  It ain’t so.

So what would I do if I were a 401(k) investor facing a limited menu of choices?

• Put 60-70% in conservative, value-oriented stock funds. (US and Foreign)
• And 25-35% in moderately risky bond funds. (US and Foreign)
• And 5% in cash.
• And rebalance yearly.  Do it after you complete your taxes, or something like that.

Avoid complexity.  Even if the plan offers a wide number of choices, winnow it down to a few funds, say five at most.  Over the long run, your investments should prosper, because you are doing things that few investors will do, and enjoy  returns from bearing risk successfully.

We can’t rely on US Treasuries?  If so, what can you do to preserve purchasing power?  I will ignore a variety of exotic strategies/derivatives and focus on things that can be executed by individuals and small institutions.

The first idea that comes to mind is gold, silver and commodities.  Commodities don’t lie, they just sit there.  But the prices don’t just sit there.  They go up and down with demand and supply.  I’m not an expert there, so I would say keep positions small, enough for diversification relative to volatility.

Idea two is foreign debt of unquestionable solvency.  Well, that takes much of the world off the table, leading to investment in the developed fringe currencies — Canada, Australia, New Zealand, Norway, Sweden, and the Swiss Franc.  Toss in the Yen, though it isn’t fringe.  Not a very large group, and their currencies have run like mad.  Could they fall?  Imagine a US default, where aggregate demand drops across the world because the Treasuries in the banks of other nations are only worth 70% of face value.  Deflation would drive commodities and fringe currencies lower.

Idea three is an echo of two — buy the debts of emerging markets with more orthodox economics than the US, Eurozone, and China.  Nice, but their currencies are high as well.  Same problem as two.

Idea four is buy high quality equities that pay dividends.  There’s a plus and a minus here.  Minus: Equities are highly sensitive to confidence / trends in aggregate demand.  Plus: equities, if conservatively financed have positive optionality, subject to the same problem you have: what is a good store of purchasing power?

Even buying needed resources ahead might not work because demand conditions might be lower going forward.

Idea five is buying high quality non-Treasury domestic debt.  Along with ideas 2, 3 and 4, this seems to be Pimco’s strategy.  But our payments system is interconnected.  Any non-payment, or serious threat of non-payment will disrupt the ability and willingness of others to pay.

Idea six is stay in US Treasury debt — where else can you go?  You’ll get paid back eventually, with interest, most likely…  Hey, TIPS could work in an inflationary scenario.

Idea seven is hold physical US cash.  That should retain value of a sort until the debt ceiling situation is settled.

My main point is that there is nowhere to hide with certainty.  There are places to diversify into, and maybe you should consider some of them as part of a broader asset management strategy.  But avoid changes motivated by panic.  They almost never work.

In a debt-driven world, with fiat currencies, everything is confusing because there is no obvious store of value offering some small (but not near-zero) yield.  A small positive inflation adjusted return is healthy for savers, and good for the economy.  Let the Fed adjust its policy, and then the hiding place would be simple — CDs.

A feast is made for laughter, And wine makes merry; But money answers everything.

 

There has been a small flurry of posts off of James Montier’s piece on the virtues of cash.  I wrote a piece like it recently (not as comprehensive, but possessing brevity): Chasing Your Tail Risk.

Like gold, cash is special because it doesn’t do anything.  Even money market funds do nothing, or almost nothing.  It just sits there, waiting.  It waits for the day when the Fed is forced to raise rates because inflation is running faster, even though the economy is still underemployed.  It waits for the day when bond yields rise and stock prices fall, where there are good opportunities to use the cash.

Having cash on hand allowed my church to buy a building cheaply in March 2009, and allowed me to help rescue a friends business, as well as buy some cheap stocks.  The same was true for me in October 2002, when I fully deployed my cash into stocks.

Cash is flexibility.

Cash says, “I don’t know.”

Cash says, “I don’t care.”

Cash says, “I’m ready.”

When opportunities are numerous, I am more than willing to part with my cash.  But when yields are low, and valuations are high if profit margins mean-revert, I would rather have more of a cash buffer.

For my account, and client accounts, I did buy some stock last week.  If the weakness had persisted, I would have bought more.

I still have an above average amount of cash (for me).  I am waiting for opportunities to get better before I deploy it.

There are many people out there following aggressive investment strategies, but they want to be covered if things go wrong.  Why not sell down the positions a little and buy some high quality short-to-intermediate-term bonds?

What!?! Give up the upside?!  They would rather buy some insurance — something that will pay off big if things go bad.

But think of the other side of the trade.  What does the one offering you insurance have to do?  It depends if they are scrupulous or unscrupulous.

Scrupulous: Set aside money or high quality assets in reserve, and treat the premiums as part of the the return on a high-yield money market fund, albeit with the possibility of a severe loss.

Unscrupulous: Don’t set anything aside.  Write as many contracts as you can.  It’s free money because there won’t be any crash.  And if there is a crash, declare bankruptcy.  After all, many others will be doing the same thing — you will have company.

Even if the contracts in question are exchange-traded, with margin posted, still the one writing the contracts and taking the risk should be ready to pay the whole wad in the disaster scenario.  Maybe the exchange will make up a few small defaults, but even exchanges can go broke if the situation is severe enough.

In order for tail risk to be mitigated fairly, someone must keep a supply of slack high quality assets.  Rather than the insurer doing that, why not have the investor do so?  The insurer brings along his own cost structure.  Why not self insure and bring down the risk level directly.  Someone has to hold high-quality assets to mitigate risk; let the investor be that party; embracing simplicity and enjoying reduced risk without the possibility of counterparty failure.

Quaint, huh?  And it doesn’t involve a single disgusting derivative, unlike those that would create a “Black Swan” ETF.

Simplistic financial plans assume a smooth return that the client will earn.  Why?  No nefarious reason, but planners don’t know the future, so they either:

1) Assume an average rate as a baseline for calculations, or

2) Display the average, median, or some  percentiles from a series of randomly estimated possible futures.

But life isn’t that way.  Markets are lumpy.  High and low returns happen more frequently than average returns.  What’s worse, returns tend to streak over years and decades.  So much for the Efficient Markets Hypothesis.

So what to do?  Better to be like the great moral philosopher Linus van Pelt, who carried a candle at night, and his sister Lucy asked him why he was doing so.  Linus replied, “It is better to light a single candle than to curse the darkness.”  After Linus left, Lucy mused for a moment, and shouted, “YOU STUPID DARKNESS!”

Volatility is a fact of life, and even the volatility is volatile, with regions of seeming stability, and regions of extreme booms and busts.

My “single candle” is simple — it is an adjustment of expectations, which involves reasoning that when things have been horrible, after some amount of time, it is time to take risk again, before it is perfectly obvious to do so.  Same thing when things are great, it may be time to take risk off the table.  I would add that delay in doing so is not a failure — lumpiness means that trends run further than would be reasonable.  But when the momentum wanes it is time to change.

I’ve been in the situation multiple times, but it is really difficult to get permabulls or permabears to recognize that something has shifted.  I wrote about this a number of times in my series “The Education of a Corporate Bond Manager.”  I was constantly fighting those who were hanging onto the old trend too long.

And at another firm, I could not convince my boss to go long once the nadir of the credit crisis had passed.  He expected more trouble to come, while I looked at the bond market and found an absence of distressed credits.

The lesson of both cases is that opportunities to earn total returns or preserve capital are lumpy.  If the market is longing for safety now, it will likely do so for a while, and the same is true for bull markets.

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Many retirees say “I just need a certain reliable income of X%/year. Please get that for me.”  We may as well tell these people to buy a CD or annuity, except that Fed policy makes the rates inadequate for their needs.  And yes, this is a deliberate policy of the Fed, picking on the elderly and the conservative in order to fund marginal lending that might  result in some tiny increment of growth.

It is far better to ask three questions:

1) Where are we now in the credit risk cycle? Rising, Peak, Falling, or Trough?

2) Where are yields on high-grade corporate bonds now?

3) Can you afford to spread your yield needs over five years?

Bond investors need to realize that most returns of the bond market are earned at three times: first, after the nadir of the credit cycle, credit-sensitive bonds soar.  Second, during deflationary times, buying long-dated Treasuries.  Third, when inflation is running, rolling over short-dated fixed income claims.  Beyond that, one can clip bond coupons during abnormal times of stability.

By asking the above first two questions, we can ascertain whether it is a favorable time to take risk or not, and what sort of risks to take.  The last question is more of a reasonableness check on the client.  If he has to have the return every year without fail, tell him to seek it at a bank or insurer, and see if he is pleased with the results.

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But now take it one step further.  When will our stupid economists and politicians get it through their heads that lumpy economic growth is normal, and even that it is desirable that growth is not smooth?  Effort to produce a smooth economy led to a debt build-up, which ultimately sabotaged growth.  Far better to let small recessions do their work, and leave the Fed funds rate high until marginal investments are repriced, with the attendant bankruptcies.

The US economy grew more rapidly when there were no efforts at stimulus.  Yes, there were severe recessions, but the booms thereafter more than made up for it.  Though it would hurt a lot in the short-run, far better to end the deficits of the US government, and the pitiful efforts of the Fed, giving greater certainty to the private sector, that businessmen could make long-term decisions without worries that taxes, regulations, or interest rates might change dramatically.

Like it or lump it, some say.  Why choose?  Learn to like the lumpiness of the asset markets and the economy in general, and many things will go more easily for you.

Rapid money supply growth with no consumer price inflation can only really occur within the confines of an asset price bubble, or else, where does the money go?  Interest rates are low at such a time because of the incredible liquidity, and complacency of lenders that they will get an equal amount of purchasing power back.  Perhaps another possibility is when a country’s currency is being used more and more as a shadow currency, like the US in the Third World.  But even that will come home someday.

I wrote this sometime prior to 2003.  But can it be more relevant than today, aside from my comment about being a shadow currency?  Alas, the US Dollar is not a store of value anymore.  It is only a unit of exchange, like trading cigarettes in a prison camp.

The Federal Reserve may pretend that it is the guardian of stability, but it is not so with respect to asset values.  The Fed stays within its mandates: labor unemployment and goods price inflation.  Those are not much affected by Fed policy at present.  But asset values are inflated.

What should we expect of monetary policy?  Additional creation of money or credit should affect the prices of something.  If the Fed does not intend on affecting a price somewhere, what is it up to?  The economy is prices.  What is the Fed if it does not affect prices?  Next press conference, ask Ben what set of prices he is trying to affect.  If he mumbles, as he usually does, you can know that he is without knowledge, or lying.  All monetary policy affects prices, and it is either dishonest or stupid to say otherwise.

That’s all for now.  We are in a rough situation because of errors in government and central bank policy, as well as cultural errors that have favored spending over saving.  Ignore the idiots who talk of the paradox of thrift.  They rely on short-term models which are not relevant in the real economy.  Saving is a good thing, but maybe save in currencies that are not subject to government discretion, like gold.