Dear friends,
A number of folks have had questions about Ed's arguments concerning the performance of traditional balanced funds. Being shy and retiring, Ed is not predisposed to post on the board but he does read your comments, often scanning them daily.
Four notes, then, as a sort of gloss on Ed's August essay:
On balanced funds: traditionally balanced funds have provided portfolio protection in falling markets because their two dominant asset classes have had correlations that were, on average, negligible (the one-year correlation over the past century is between 7-
10%) and, in times of economic decline, negative (the correlation has been as low as -93%). The Depression, for example, saw consistently strong negative correlations. Cash, at the same time, was not correlated with either. In the past couple decade, the Goldilocks correlation has been positive: both asset classes rose as interest rates fell.
That's been good for investors and helps explain why the Vanguard Balanced Index fund (VBINX) has been nearly unbeatable: dirt cheap, fully invested, religiously rebalanced between two rising asset classes. But correlations tend to be dependent on two factors: beginning valuations and the rate of inflation (hence, of rising interest rates). A combination of pricey assets with rising prices cause stocks and bonds to become positively correlated (as high as 89% correlated), prominently in the inflation wracked '70s. That data is all courtesy of
a 2013 PIMCO study. "This analysis," they conclude, "challenges conventional wisdom for asset allocation."
Ed's argument: all three asset classes might be subject to sharp, sustained declines over, say, the next decade. As a deep value investor, he's pretty much appalled by what he sees as a fundamental disconnect between corporate prospects and stock prices. Bond yields can't go any lower unless you anticipate investor acceptance of negative yield, of the sort Switzerland is getting away with: instead of paying interest, the Swiss government promises to return your principle, minus a modest annual holding fee, in a decade. An article in the August 6 Financial Times heralded the sea change in the nature of bond investing, from "risk-free returns" to "return-free risks." And money market reforms now allow money market funds, often used in mutual fund portfolios, to use variable NAVs; that is, for the first time you might buy a MMF at $
1.00/share and see your shares soon priced below that.
It's likely that a balanced fund will still be less-bloodied than a pure equity fund but it still might be surprisingly bloody for years. How many? A balanced fund
could remain underwater for six to eight years if the bond portfolio doesn't offset the declines in the equity portion. The New York Times published
an okay short piece on recovery times, noting that the average recovery time since
1900 for the stock markets has only been about two years, buoyed by dividend yields as high as
14%, but that six to eight year periods can't be discounted.
On 1987 and 2007: the argument is that 2007 initiated a slow-rolling disaster where markets fell, rose, steadied, fell, rose, fell, steadied, fell ... That gave "the smart money" time to reposition to minimize the bloodshed. The market in
1987 rose 44% between January and August, turned choppy for eight weeks, then the crash rolled out over just four trading days in the middle of October: Wednesday (-3.8%), Thursday (-4.2%), Friday (-4.6%) then Black Monday (-22.6%). Markets worldwide fell 40-60%.
Analysts tend to attribute the crash to geopolitical instability (uhhh, Iran was firing Silkworm missiles as U.S.-flagged merchant ships) and computerized trading. "Portfolio insurance" programs, designed to minimize losses by selling fast in the face of a declining market, may have created a negative feedback loop in which each sale triggered a new alarm and another sale. Such algorithms were the province of ultra-sophisticated investors in
1987, today they're common though no one knows
how common since the folks who use them don't necessarily advertise the fact. The highest number I've seen is 84%, a common number is 70% and the most conservative is 50% of all U.S. equity trades.
The question is, does the rise of artificial intelligence and its deployment by the ultra-sophisticated minimize or heighten the prospect of an "oops" on a truly global scale. I suppose if you find the widespread deployment of drone into our airspace reassuring (pretty pictures!), you're also likely to find the widespread deployment of AI in the financial markets reassuring.
As an investment concern, the difference is important: you
can't react to a
1987-style event, you can only endure it or try to find satisfactory ways to permanently hedge your portfolio in advance. Given the doubts, above, concerning a balance strategy and the availability of insured one-year CDs paying
1.25% (with
12-month inflation at just 0.
1%), Ed might recommend that you seriously consider the latter.
On paring his portfolio: Ed's wife, from time to time, points out that he has no rational need for 25 mutual funds. I get the impression he sighs, looks at the lot of them, thinks "but he was so promising as a baby!" and then chucks one of them out of the sleigh. I'll let you know if he shares a more-detailed methodology.
On the difference between Ed and me: I'm the taller one, he's more ... uhh, full-figured. Edward used to co-manage a multi-billion dollar mutual fund, I peaked out at mismanaging my multi-thousand dollar 403(b) account. The other difference is that Ed writes
everything that appears under the banner "Edward ex cathedra" while I churn out the fluff and babble. Which I mention just for the sake of folks who are new to the Observer and have misattributed some of Ed's arguments, observations, grumbling and/or brilliance to me.
Back to patching the concrete at the end of my driveway,
David
