Archive for the ‘Changing Times’ Category

As those of you who have been acquainted with us for long know well, we believe avoiding the Style Box approach to investing that is promoted by Morningstar is the best thing you can do. Style boxes provide very little true diversification and drag down portfolio results by as much as 3% per year.

Now, Advisor Perspectives has published an interesting study showing that the Morningstar Star Ratings fail to predict performance through a market cycle. So, moving from a “3 star” fund to a “4 star” fund is no better than flipping a coin to decide which fund to hold. Russel Kinnel of Morningstar admits the star rating is “not a forward looking measure”.

This finding does not surprise us at all. Investing with style boxes and star ratings using a rear view mirror approach is a losing concept, particularly in a secular bear market. You need strategies and tactics that make sense moving forward, emphasizing return of capital as well as return on capital.

Should you be a buyer or a seller between now and year-end? That seems to be the question on everyone’s mind as we enter December. The answer is, of course, that it depends. If you were wise enough to invest early in this bull market you should be considering peeling back some risk at this point.

That is, reducing your level of investment in high yield bonds and/or low-quality stocks. We would not advise abandoning them altogether but taking some reasonable profits. If, on the other hand, you are late to the party and are now thinking about taking money from the sidelines and placing it back into the market we would suggest you do that with caution. Specifically, you don’t want to chase gains that have taken assets to above fair value. Many parts of the market are currently overheated and likely will not produce above-average results going forward.

Looking at it in another way, you need to determine whether the odds are on your side or against you going forward. They certainly don’t seem to us to be strongly in your favor. On the other hand, we certainly have no reason to be sure that the market will not continue to run from here. A plan to cautiously reinvest might be the most prudent. You could plan to buy into the market monthly for the next six or eight months. If we did then see a market correction, you could use that opportunity to alter your plan and  purchase more aggressively into the market.

Your focus should be on buying high quality assets on which you have conviction that they will do well for years to come. That should be a recipe for success as we move forward through turbulent waters.

The market surge continued this month, though perhaps sanity is beginning to finally come back to the table. For the first time during this huge rally, quality seemed to matter a bit. The Russell 2000 (an index of 2000 small companies) has fallen to its 90 day trading average while the indexes of larger companies continue to trade well above their average. We see this as a trend that is likely to continue for quite a while. We have no idea whether this market is at a top right now, but we do know that the risks are growing that we could see a correction at any time. When the correction comes, do you want your portfolio focused on quality companies selling at average prices or low quality companies with no current earnings? To us, that is one of the easiest questions to answer that we have seen. The strategy, oft times referred to by Jeremy Grantham, is known simply as “survive to fight another day”. If you own good quality companies with earnings and dividends, they will still be around in a couple years even if we hit another large market slide. We can’t say that is true about owning a small company with no earnings in this economic environment.

On the flip side, we also expect the higher quality stocks to outperform should this market continue to escalate. These companies have good earnings, fair pricing, cash on hand, etc. Their future is bright, they have to wear shades! On the flip side, we continue to have a negative outlook for the Russell 2000 stocks.

In currency, we think the dollar may have a short rally in coming months, followed by a return to weakening against emerging market currencies. While we hope to participate in this area, we are not rushing into it with guns a blazing as we think the dollar may rally for a bit first.

Lastly, do we think the economy is fixed or sinking? That seems to be the topic that everyone is weighing in on. Our belief is that it was not as bad as most thought last November and isn’t as good as many think this November. We think things are getting worse more slowly and that the turnaround will be slow and muted from here. That seems to us to denote a period of slow growth and small returns, not the continuation of a huge bull market that   will make us all rich.

We spent a day recently with a group of advisors who cling to all the orthodoxies of financial services (Modern Portfolio Theory, static asset allocation, etc.). According to them, all you need to do is divide up your money into a bunch of style boxes (e.g. large company value stocks) and keep it there. We know that this has been a dangerous belief for the last decade and we think it will continue to be dangerous in the future.   But, it got us thinking about what people still call “modern”.

Modern Portfolio Theory basically states that the selection of assets (stocks, bonds, and cash) is the major factor in determining risk and return for a portfolio. It was developed in the 1950s by Harry Markowitz. That is over 50 years ago. Is it time to re-consider whether we need something even more “modern”? Markowitz, of course, never talked about the style boxes that have become part of the orthodoxy of financial services. Style boxes were invented by Morningstar in the early 1990s. So, a marketing scheme that was invented more than thirty years later has come to be considered by many financial advisors to be an essential part of “modern portfolio theory”. What else has transpired since this modern theory was published?

Hawaii and Alaska became states the year that Markowitz’ book was published.

WalMart was founded in 1969, a decade later.

The NASDAQ stock exchange began in 1971.

The first color television broadcast was in 1974, 25 years after the “modern” theory.

The term personal computer was first coined in 1975.

Enron did not come into existence until 1985.

The World Wide Web was invented in 1989.

So, we shouldn’t throw out Markowitz’ theory because of its age, but we need to consider whether or not it still applies and perhaps tweak it a bit if it is to be relevant in the 21^st century. A few things may have changed during the past 50 years! Perhaps most importantly, his message has been transformed to mean what the financial services industry wanted it to mean rather than what he actually said. He never told anyone to fill a bunch of artificial “style boxes” and hold on to overpriced assets in a bear market. That would not be a Nobel Prize winning concept.