Academics Rule the World

With the Federal Reserve prominently in the news again this week, having finally begun to reduce the amount of monthly stimulus, a few thoughts continue to nag at me. I offer the following for your consideration.

Having lectured over the decades at several nationally reputed colleges and universities, I have a very special place in my heart for men and women who dedicate themselves to educating subsequent generations. Most are very intelligent and extremely well informed in the areas of their specialty. A great many for-profit and not-for-profit organizations call upon such academicians for counsel as consultants and, in some instances, as board members. Imagine, however, a good sized corporation having a board of directors composed almost entirely of academics with virtually no direct business experience. That doesn’t happen. Imagine further that it were a giant corporation like GE, Microsoft, Wal-Mart or IBM. Inconceivable! How about an entity many times bigger than any of those that has a direct effect on virtually the entire world economy? That entity is the Federal Reserve.

While I have spent no time studying the curricula vitae of the Fed’s current board of governors, I have heard references to business experience only about Dallas Fed President Richard Fisher, who had prior hedge fund involvement. Several members have served in regulatory roles, but that’s far removed from hands-on business experience. How could we have arrived at the point at which we allow academicians, regardless of how intelligent, to function as world financial central planners? World business leaders have been remarkably silent about the need to interpose some practical business experience.

I can only presume that such silence stems from not having their ox gored in recent years. For the past decade and a half or more, the Fed has done little but let the good times roll. And what corporate CEO doesn’t like free flowing money? In the past five years in which the Fed has created more than 3 trillion new dollars and has usurped far more power than was ever expressly granted to it, corporate leaders have had no cause but to celebrate.

We can only hope that common sense will soon prevail and that a huge public outcry will arise against a small cadre of academics holding the reins of the world economy. The rationale for such an outcry becomes all the more obvious when we consider Boston Fed President Eric Rosengren’s recent description of current Fed policy as “experimental”, “trial and error”, and “learn by doing”. And he’s a supporter. This condition would be comical in the extreme if it were not so horrifically scary.

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Two Important News Items

Because of travel, this was a short week in the office. Nonetheless, a couple of news items deserve highlighting.

With stock prices on many major domestic indexes just off all-time highs, investor enthusiasm has grown stronger and stronger. The Investor Intelligence Advisor Service shows the highest percentage of bulls since the 2007 top that preceded a 57% decline in the S&P 500. The percentage of bears is now the lowest since 1987, just before the market’s 35% crash. The Daily Sentiment Index registered two 93% bullish readings in late-November, the highest in two years. According to The Elliot Wave Financial Forecast: “The only equal or higher readings since the peak of 2007 were single extremes of 93% bulls in February 2011 and 94% in November 2010. In the peak year of 2000, the only comparable extreme was also a lone 93% bullish reading on August 31, 2000…,” virtually the stepping-off point for the second market collapse of the still young 21st century.

Mission’s 2-Mode and 3-Mode equity allocation processes pay considerable attention to investor sentiment. These extreme sentiment readings are a clear negative in those quantitative formulas, currently offsetting other more bullish readings in such areas as money supply and price momentum, thereby leaving the formulas in a neutral zone.

A second news item worthy of note was Time’s naming Pope Francis its Person of the Year. While any pope has a bully pulpit to some degree, this week’s recognition is an acknowledgement that this pope is heard more widely than most, at least in modern times. I have no idea of Pope Francis’s level of financial sophistication; I suspect it’s relatively limited. Nonetheless, he is speaking out on economic matters, and the response he has elicited is testimony to the fact that his message is being heard. His admonition of today’s capitalism for its tendency to accentuate the gap between rich and poor may or may not be an insightful commentary on a system that has created great wealth and progress, much of which has benefited the poor, albeit in far lesser degrees.

As readers of this blog know, I have argued strongly against the super-loose monetary policies of the Federal Reserve. I contend that it is an immoral policy that is stealing from savers–most particularly from retirees–to benefit bankers and the wealthiest 1% of our society that owns a major portion of the assets whose prices are being elevated. The resultant debt burden that will be transferred to future generations will affect rich and poor alike with a financial encumbrance they had no voice in approving.

The relatively small voice of the opposition has clearly not deterred Fed actions. And while the pope is hardly directing his commentary to the Fed, we can hope that his voice will stimulate Fed Governors to consider more carefully the deleterious effects of their choice of winners and losers.

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Frequency Of Transactions Reflects Cautiousness

Since introducing our formularized equity allocation processes in late-2012, we have had numerous opportunities to hear opinions and to field questions from clients and non-clients alike. A very high percentage of clients have chosen to add one of the two allocation methods to the equity segments of their portfolios. Fortunately, year-to-date the processes have produced a double-digit return while exposed to equity risk less than 40% of the time.

A few weeks ago the chairman of a large non-profit’s investment committee suggested the 3-Mode to be essentially a trading vehicle. Our meeting was his first exposure to the process, and the frequency of signal changes (an average of 16 per year over the past 33 years) could logically lead to that perception. My response addressed his concern by explaining how the method differs very substantially from trading.

Most traders buy or sell a security or an index based largely on attractive technical factors with a fairly specific price target in mind. Fundamental considerations may well also be evaluated but rarely dominate the decision-making process. Our execution of the 3-Mode process is demonstrably different from a typical trade.

When the process issues a buy or sell signal, it does so with neither price nor time target in mind. Through a measurement of dozens of fundamental and technical factors, the process merely indicates that the equity markets are more likely to rise or to fall in the indefinite period ahead so long as conditions remain as they are currently. Over 33 years of observation, such signals have lasted for well more than a year and, in a few instances, for as little as a single day. At the time a signal is produced, nothing indicates the likelihood of a long or short time period. Changes in conditions dictate the longevity of a signal.

When we describe the process as “formularized”, we’ve had some people question whether this is a kind of black box magic. It’s far from that.

How do most investment analysts, strategists and managers make their security selection decisions? Most evaluate a collection of macro conditions and a variety of security specific data. Since we employ exchange-traded funds replicating the results of broad stock market indexes, we can skip considerations specific to individual companies and concentrate on factors that affect the overall market.

While some investment professionals focus on just one or a small number of critical fundamental and/or technical conditions, most examine a broad array of factors in determining the attractiveness of the environment for stock ownership. We similarly examine a very large number of economic and market related factors, mostly domestic but some international, some fundamental and some technical. The data that we evaluate are widely reported and are critical to the investment decisions of the majority of investors.

Like most investment professionals, we consider money and credit conditions to be very important. We assess Fed policy, rates of money growth, the availability of funds for investment, rates of inflation and changes in interest rates at several points along the curve.

Investor sentiment provides a meaningful contrary weight in our analysis. We assess traditional valuation measures, market-wide stock earnings yields, overbought / oversold statistics and a collection of sentiment surveys.

Over the years we have been impressed with the predictive accuracy of several outside data studies, both domestic and international. We buy a number of those, and a few are included as components of the equity allocation processes.

Notwithstanding the predictive ability of a great many studies as well as evaluations of individual economic or market conditions, virtually all have experienced one or more major failures if traced back over the decades. Not-for-profit institutions and retirees comprise the bulk of our clientele, and neither can easily replace significant amounts of lost capital. The make up of our client base created a need to guard against even a single substantial loss. While the investment markets don’t lend themselves to guarantees, we had to be sure that the processes had a very high probability of avoiding unacceptable losses.

Prior to offering the equity allocation processes to our clientele, we had to uncover what we have categorized as the last piece of the puzzle. By including a heavy weighting of measures of price movement and price momentum, we were satisfied that we had an approach that had strong potential to outperform major equity indexes over full market cycles. Most importantly, in back-testing for nearly a third of a century, we found that our combination of factors not only outperformed equity indexes in the long run, but did so with fewer and smaller losses, a necessity for our clientele.

Nothing in our analysis is unique or even uncommon. The major difference between Mission and most other managers is not the data that we evaluate. We simply quantify the results of our many studies, rather than relying on a more subjective evaluation of their findings. That quantification serves the valuable purpose of eliminating ego and emotion from the investment decision-making process. Neither newspaper headlines nor an endless stream of talking heads on financial TV play a role. The processes provide a positive signal when the cumulative array of data produce a level of strength that, over the past 33 years, have coincided with periods of positive market progress with a relatively high degree of probability. Conversely, negative signals occur when the cumulative data coincide with the readings they have provided when markets have declined over the past third of a century. Neither these processes nor any other decision-making process can guarantee positive results, but we have chosen to let carefully documented historical probability over a great variety of market environments dictate our equity allocation decisions.

While back-tested results can never predict the future with certainty, we believe these formularized approaches will continue to provide positive results for three reasons: 1) the results have been obtained with considerable consistency over more than three decades in quite a variety of market environments; 2) the factors evaluated are numerous and diverse, so a few becoming less well correlated with market success or failure will not likely eliminate the effectiveness of the overall formula; and 3) the heavy weighting of price movement and price momentum has been quite successful in avoiding significant losses when most of the factors are pointing in one direction but prices are moving in the opposite direction.

Let me return to the original question. Is the 3-Mode process just a trading vehicle? Our 2-Mode and 3-Mode processes evaluate exactly the same data. The 2-Mode has historically experienced an average of just one signal change per year, far from typical trading frequency. The 3-Mode averages 16 signal changes per year, because it has far tighter risk tolerances. It moves out of a long or short position when the data become less certain. It is willing to forego some profit on either the long or short side when predictability declines. As a result, it has achieved an annualized return of about 400 basis points above the S&P 500 without having experienced even a single double-digit loss in a calendar quarter, compared to eleven such losses for the unmanaged S&P 500. More frequent transactions for the 3-Mode are a function of significant cautiousness rather than traditional trading tactics.

Please contact us if you would like more information about either or both of these equity allocation processes.

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Happy Thanksgiving

I have taken an unintended break from blog writing over the past few weeks. It certainly has not been for lack of subject matter. Stocks are hitting new highs; fixed income yields have risen sharply since the historic lows in mid-2012; the Fed keeps pumping massive amounts of money into the system; Janet Yellen is about to take Ben Bernanke’s chair; domestic economic growth remains the slowest in any post-recession recovery on record; Europe is still struggling to emerge from its multi-year recession; inflation rates are receding except in emerging countries, where they have risen far enough to create some concern.

A combination of travel, the regular workload and the enjoyable opportunity to lecture on investments and the Fed in a couple of classes at the University of Arizona have prevented me from putting in the needed time to produce a blog entry. With travel again filling next week, it’s not likely that I will post anything then. I hope to be back to a somewhat regular schedule in December. In the meantime, I hope all of you will enjoy Thanksgiving with loved ones.

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3rd Quarter 2013 Market Commentary

Funds that clients have allocated to our formularized equity allocation process have grown by low double digits so far this year, although third quarter results were essentially flat. Those assets were exposed to equity risk just 39% of the time year-to-date. With interest rates having risen substantially since mid-2012, most bond returns have been negative for more than a year. We have avoided those losses by holding most non-equity portfolio assets in long-dated certificates of deposit with coupons near 2%. When attractive, low-risk alternatives materialize, we have the right to cash out of those CDs with minimal prepayment penalties. In the meantime, they improve the portfolio’s income return in a historically low rate environment. Our small gold hedge improved in the quarter but is down from earlier highs. As long as central bankers remain intent on aggressively growing their money supplies, we will increase our gold hedge if we can do so at progressively lower prices.

The next few years present very difficult prospects for individual investors and fiduciaries of institutional funds. Risk-free investments provide essentially no return, and the Federal Reserve has expressed its intention to maintain that condition for the foreseeable future. All but the shortest investment grade fixed income securities have lost money over the past five quarters as rates have risen. The Fed and most analysts have forecast a continuation of rate increases over the next couple of years. Should rates rise aggressively for any reason, bond portfolios will be punished. Equities have continued their upward march in much of the world, especially in the United States and Japan, the two most aggressive money printers.

Simply ignoring risk and holding stocks would have been the most profitable course over the past few years. Equity investors today, however, are confronted with a highly unhealthy environment. Reaction to the weak September employment report demonstrated clearly that investors are largely ignoring weak fundamentals and are celebrating the likelihood that such conditions will defer the date when the Fed will slow its monthly stimulus. Investor behavior around the world has mirrored that response. When Fed Chairman Ben Bernanke first hinted that tapering of the stimulus was likely soon, markets around the world fell–some precipitously. Caught apparently by surprise, Bernanke quickly committed a cadre of Fed governors to the task of calming the markets. Most world markets were then in negative territory for the year. When the Fed began to indicate that economic conditions were sufficiently weak to warrant continued full-bore stimulus, markets again began to rise. The subsequent presidential appointment of Janet Yellen as the next Fed Chairman seems to have reassured equity investors that their monetary drug of choice will continue to flow. Bad economic news incongruously remains good stock market news. That puts the true investor in a severe quandary. Should he/she just keep betting that the Fed’s unprecedented monetary policy will continue to work, or do weak fundamentals actually matter?

Seemingly lost in investors’ obsessive concentration on the free flow of massive monetary stimulus is the burgeoning level of debt that is the inevitable result. In a mere five years, the Federal Reserve has quadrupled its balance sheet. Notwithstanding reassuring words from Bernanke and others, many analysts, including some members of the Fed itself, express grave misgivings about how the Fed will ever be able to unwind its bloated balance sheet. No central bank has ever faced such a gargantuan task, so there is no blueprint for success. What evidence there is from much smaller endeavors of a similar nature is far from reassuring. Severe indebtedness is most typically resolved through significant inflation. That doesn’t appear to be an imminent risk, but it certainly remains a long-term concern. That Japan and the Eurozone have even more egregious debt loads relative to their economic output merely adds to the background risk for all investors.

Unless one takes the position that the debt bill will never come due, retaining equity gains is likely dependent on investors’ ability to step away before confidence dissipates in central bankers’ capacity to control financial and economic outcomes. Such gambling is a far cry from traditional investment analysis.

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Update on Our Formularized Asset Allocation Processes

The majority of Mission’s clients have chosen to have us employ one of the two asset allocation processes that we introduced in 2012. Both processes have gotten off to productive starts. In the ten months since the first purchases last December, assets invested with the processes have produced low double-digit returns, although just a small portion of that was earned in the last few months. Assets have been exposed to equity risk only 43% of the time since that December start. Those who chose to employ one of the processes in the early months have experienced the strongest returns.

Ten months of real time experience have led to quite a number of questions, which indicate a need to repeat several of the points we made in our introductory meetings and to clarify the reasons behind some process signals. I will address some of those questions here, and we encourage you to contact your portfolio administrator with other questions you may have.

A quick refresher. The 2-Mode Equity ETF model attempts to own stocks when equity markets are advancing and to keep portfolios safely in cash equivalents when markets are declining. The 3-Mode Equity ETF model attempts to own stocks in the most attractive market environments, to keep portfolios safely in cash equivalents in uncertain market environments, and to short stocks in the weakest market environments. While there are some situations in which we would employ individual stocks, in most instances we use highly liquid exchange traded funds (ETFs), which move in step with major market indexes.

We began to search for an alternate approach to equity investment a few years ago, when the extraordinary actions of the Federal Reserve markedly changed conditions in our domestic securities markets. Our deep discount, value-based equity selection process that had produced outstanding equity returns for more than 20 years suddenly identified very few purchase candidates. At times, not one was coming through the identical screens that had formerly produced many dozens of attractive buyable stocks. Market conditions had clearly changed.

Last year we finally identified a multi-dozen collection of economic and market measures that could be combined into a formula that had outperformed the S&P 500 for more than three decades. Most importantly, the formula had done so with fewer and smaller losses than the broad market index had experienced. While successful past performance can never point with certainty toward similar future performance, we have a high degree of confidence in the two equity allocation processes for three reasons: 1) they have produced excellent returns with considerable consistency for nearly a third of a century; 2) the factors measured are numerous and diverse, leading us to expect continued success even if some of the measures become less well correlated in the future with market directions; and 3) price movement and price momentum are heavily weighted in the formula, which is designed to keep us from overstaying in a long or short position that is losing money.

Let me address a few questions. One client who started with the processes several months into 2013 had the unfortunate experience of two small losses marking his first exposure. He asked whether we were reevaluating our support for this approach. At each of our introductory meetings we have attempted to point out the worst periods in the nearly 33 years of back-testing. The 2-Mode and 3-Mode processes have lost money in 16% and 22% respectively of the calendar quarters over that time span. The S&P 500, however, has lost money in 30% of those quarters. Losses can’t be avoided completely. The worst performance quarters for the 2- and 3-Mode processes have been -10.5% and -8.6% respectively compared to -22.5% for the S&P 500. The worst 12-month performances for the processes were -7.9% and -11.7% respectively compared to -43.3% for the S&P 500. Over the years there have even been extended periods in which the market has done considerably better than either of the processes. In the long run, however, both processes have outperformed the market far more often, leading to their long-term outperformance. Notwithstanding occasional missteps, we expect positive long-term performance.

When another client received his March quarter report, he noticed that the process was up more strongly than his full portfolio. I reminded him that we only apply the process to that portion of the portfolio that he wants invested in equities. While we have a few clients that have asked us to apply the process to their entire portfolios, most have restricted it to lesser percentages. Given the volatility of any equity approach, a reduced exposure is appropriate for most investors.

A client who employs the 3-Mode process asked whether we had made any money on the short side in the three-week decline from mid-September to early-October. We did not. In fact, in the first 10 months the 3-Mode process has not yet gone short, although historically it has been short about 20% of the time since the early 1980s. While some signals last a short period of time, in an extended uptrend it is not typical to see a bearish signal interposed. This year has seen a larger than normal number of signals, because the formula has vacillated between bullish and neutral. While prices have largely risen, justifying the bullish signals, significant uncertainty is apparent in several of the measured criteria, which has resulted in several trips back into the neutral zone. It is also important to recognize that the processes typically will not outperform the market in its strongest phases. The assets are not invested in stocks all the time. The 2- and 3-Mode processes have gained their advantage over the S&P over time by participating in equities about 60% and 40% of the time respectively, then avoiding most of the major declines (2-Mode) and profiting by shorting many of the extended declines (3-Mode).

As you experience these newly implemented processes over a longer period of time, we encourage your questions. We hope to provide a solid understanding of how the processes identify positive and negative market environments.

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Bridge to Nowhere

Veteran floor trader Art Cashin has argued for the past week or two that the stock market has come to believe in a “rationality put.” In other words, investors expect that at the brink of disaster, reasonable people will ultimately vote against choosing the disaster alternative.

The current situation surrounding the imminent debt ceiling decision and the pending budget debate is a case in point. None but the most strident libertarian wants to see the government shut down – minimized perhaps, but not shut down. Yet both parties are spending considerable time in front of reporters and TV cameras ascribing such base motives to the opposition party that they might have to settle for shut down as the lesser of two evils.

In an already precarious economic environment, even a brief shut down could have seriously disruptive effects. Virtually all commentators agree that an extended shut down would push the economy back into recession. Nonetheless, investors remain quite calm.

Despite this shut down concern, Syria, and the explosion of central bank balance sheets around the world, the U.S. stock market is barely 2% off its all-time high. There is a remarkable level of confidence that responsible authorities will come to the rescue before any dire situation devolves into catastrophe. It’s logical to suspect that such complacency has been born of the parade of successes that legislators and central bankers have produced over the past five years in pulling economies and strategically important institutions back from the brink of disaster.

It is important to recognize, however, that the problems that have pushed us to the brink have not gone away. The debt problems in the U.S., Europe, Japan and elsewhere have been papered over with more debt. The budgetary problems, which are effectively also debt problems, have been partially addressed by austerity, which is wearing extremely thin in many parts of the world. The majority of these budgetary problems have been deferred, leading to the well-worn phrase “kicking the can down the road.”

Denial and deferral efforts by governments and central bankers remind me of the construction of a bridge to nowhere. Here in Arizona the Hualapai Tribe has built the Grand Canyon Skywalk, a platform built out over the canyon with a transparent bottom. Visitors can walk out and look straight down to the canyon floor. Clearly the structure meets engineering standards and is properly anchored to the canyon rim. Analogously, whether today’s level of debt is properly anchored is subject to debate. It is obvious, however, that the skywalk of new debt over already existing problems cannot be extended too far without collapsing, unless it can be anchored on the other side. At this point, there is nothing firm on the other side to which to attach the rescue skywalk. There is simply a pledge issued by various central bankers to do whatever it takes or to continue balance sheet expansion on a data dependent basis–in other words, to keep extending the skywalk indefinitely. It wouldn’t take structural engineers long to fathom the folly of such planning. Why is it so much more difficult for financial engineers to perceive the obvious?

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More Joy In Mudville – Mighty Casey Hits A Communication Homer

Stock prices showed again on Wednesday how in thrall they are to Federal Reserve action.  Seconds before public release of the Fed’s decision (again showing probable advance notice), equity and gold prices exploded upward; bond yields and the U.S. dollar plummeted.  The Fed decided against tapering their $85 billion per month bond buying program, and punters celebrated the prospect of no near-term monetary discipline.  The Fed’s friendly overture to the market produced about a 240 Dow point rise from the day’s low to its peak with 140 of those points materializing in the first minute while TV commentators were still reading the Fed’s announcement.  Needless to say, these buyers were not Mr. and Mrs. Main Street.

Just a half-hour after the announcement, Fed Chairman Ben Bernanke sat before the press explaining the Fed’s hesitancy to initiate the anticipated tapering.  In a forum in which Bernanke committed a misstep that unwound a similar powerful price run in his last appearance, he managed to maintain investor confidence this time.  Although he dodged a couple of questions, he carefully threaded his way between the need to admit enough economic weakness to justify the extraordinary stream of monetary stimulus and the danger of frightening his audience into focusing on just how precarious economic conditions truly are.  The strength of stock prices through the end of the day testifies to his success in hitting a communication home run.

Increasingly the Fed appears to be caught in a precarious position with respect to taking its foot off the monetary accelerator, because the economy is simply not improving enough.  It is at a point from which it can’t possibly admit defeat.  If the economy doesn’t improve (or worse yet begins to weaken), the Fed now apparently believes that it has to continue its extraordinary monetary policy without regard to future consequences from even more monumental debt burdens.

Helping to obscure potential future problems, respected investment research firms point to the expansion of central bank balance sheets–especially those of the U.S and Japan–as an unqualified good.  No mention is made of the ultimate problem of already excessive debt becoming even more excessive, even though a multi-century record points to one to two decade long economic disruptions as the probable outcome of such profligate central bank behavior.  We’re witnessing the quintessential celebration of near-term reward at the expense of probable long-term pain.

This Fed inaction brings the U.S., and likely others, even closer to what Lacy Hunt and Van Hoisington term the “bang” moment.  That point can appear quickly as investors come to the belief that a country cannot repay its debt without seriously devaluing its currency.  Suddenly interest rates skyrocket, as occurred most recently in Greece before European monetary authorities pledged a rescue.  It’s timely to recall the words of former St. Louis Fed President Bill Poole to the effect that when you look at the numbers, the U.S. is only a bit behind Greece.  And there is no entity big enough to bail us out if confidence in the Fed fails.

Since the end of the 1990s, I have been warning incessantly about the uncontrolled expansion of debt and derivatives.  We have already experienced two debt-fueled debacles since the turn of the century, yet investors are once again ignoring the dangers of new record levels of debt.  Almost as a parenthetical aside, I have regularly admitted the possibility that central banks could succeed at inflating away massive debts while simultaneously floating stock prices higher on that wave of inflation.  That outcome is clearly what central bankers are attempting to orchestrate, but the record of history does not accord such behavior a high probability of long-term success.  As a firm that pays close attention to fundamentals, we have been unwilling to make that bet.

Today’s economic and market conditions create a horrible quandary for investors who make decisions on the basis of economic and corporate fundamentals.  By judging it necessary to create money at unprecedented rates, the Fed indicates a clear belief that the underlying fundamentals are precarious at best.  The only reason for true investors to buy stocks at their all-time highs is a profound faith that these central planners will ultimately be able to overcome lackluster fundamentals with a flood of stimulus unaccompanied by serious negative consequences.

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The Importance of Weighing Probability and Consequence

U.S. equity investments have grown at roughly a 10% per year rate over more than two centuries.  Over that span, this country has evolved from a frontier economy to the most powerful economic force the world has known.  Given our entrepreneurial spirit and still substantial economic freedom–notwithstanding growing regulatory burdens–there is no reason to doubt that the United States will continue to make great economic strides in the century ahead.

Despite impressive long-term economic and stock market progress, recessions and bear markets have interrupted the upward march with considerable frequency over the decades.  Were it not for those inconvenient and sometimes long-lasting interruptions, buying and holding a portfolio uncluttered by anything but common stocks would be the optimum prescription for most investors.  Obviously, it’s not that simple.  Only this year did the S&P 500 rise above its level of early 2000.  Most investors, especially those in or near retirement, could not easily ride out the roller coaster pattern that has unfolded since the turn of the century.  While the economy and markets have survived the turmoil and have risen to new highs by many measures, there was no certainty that would be the outcome to the 2008 crisis.  As has been widely admitted, the world financial system was in severe danger of completely shutting down before the Federal Reserve and Treasury implemented their still ongoing monumental rescue programs.

Based on two centuries of history, investors in 2008 would have been betting with the probabilities to simply ride out the storm and continue to hold their equity portfolios.  In fact, that strategy would have proved profitable.  On the other hand, the consequence of a failure of the experimental government rescue programs could have led to a collapse into another depression, according to those charged with dealing with the crisis.  If the same scenario had been played out 100 times, rather than just once, the outcomes would likely have been quite different a good percentage of the time.  Historically less probable and more destructive outcomes would undoubtedly have occurred several times.

That is a relevant consideration for investors today.  Probabilities still argue that stock prices will continue to rise in the long run.  Most investors, however, are uncomfortable simply riding out occasional lengthy price declines.  Almost no investors are willing to risk a collapse of the financial system, as nearly unfolded in 2008, unbeknownst beforehand to most investors.

While it is clear that government largesse has replenished bank capital, government debt levels have exploded over the past five years.  Regardless of long-term positive return probabilities, there remain very real possibilities of major systemic collapses.  Entire countries in Europe and banking systems that hold their sovereign debt remain in jeopardy of default.  Detroit could be the first of many cities and states in this country that cannot pay all of its bills.  Will the related central banks be willing and able to bail them out?  Will investors retain the requisite confidence in these central bankers, allowing them to provide a worldwide safety net?  Confidence can be an ephemeral thing, and no one can guarantee that such confidence will remain firm.  A possible consequence of failed confidence in the ultimate economic and market saviors is an economic and market collapse at least as severe as those already suffered twice in this still young century.

If you have a multi-decade time frame and patience to withstand even the worst market declines, you can play the long-term probabilities and stay fully invested.  If, on the other hand, you are like the vast majority of individual and institutional investors, neither your time frame nor your patience extends far enough.  The consequences of failed central bank rescue efforts would be unacceptable, and must be avoided.

We have urged those in the latter camp to abandon the traditional buy and hold approach for the bulk of their investment portfolios.  For our clients we have adopted a formularized equity allocation process for an appropriate portion of each portfolio.  While the process certainly cannot remove all risk, it has provided strategic and profitable equity exposure.  At the same time, the components of the process are designed to dial back equity exposure based on readings from time-tested defensive criteria.  We strongly encourage all investors who could not withstand strong negative consequences to reduce their long-term risk exposure and to find a strategy designed to keep all equity exposure within their sleep-at-night tolerance.

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Has The Tide Begun To Turn?

Regular readers of my blog know that I consider current economic conditions as well as the stock and bond market rallies since 2009 to be highly artificial due to the unprecedented and extraordinary Federal Reserve intervention supporting them.  That view doesn’t make the rallies and today’s economic circumstances any less real; they are what they are.  The resultant debt and related market and economic dislocations, however, make today’s condition highly unstable and dangerous.

At the first hints in May that the gravy train might be slowed – far from stopped, stock and bond prices fell aggressively.  Many subsequent calming words from a variety of Fed spokesmen prompted a recovery bounce for stock prices.  Bonds, however, did not benefit from a similar rally.  In fact, the price decline has been so severe that since Bernanke’s May outline of a tapering scenario, most bonds have lost all interest and capital gains of the past two years.  Most bondholders have never experienced such losses.  They last occurred more than 30 years ago.

There is no way to measure how durable is investor confidence. Stock markets have historically been far more volatile than bond markets.  Should today’s confidence disappear, stocks could similarly give back years of gains more quickly than most investors can imagine, given the lack of sound fundamentals beneath today’s market prices.

The behavior of both stock markets and currencies of emerging countries has sounded an ominous note.  In a matter of just one month, the threat of slowing worldwide liquidity precipitated a nearly 20% equity price drop among the emerging countries considered the new engine of the world economy.  Such action might have been largely disregarded in decades past, but with emerging nations now comprising about half of the world’s economy, their cumulative impact could prove a determining economic force in years ahead for developed and emerging nations alike.

It is possible that the central planners occupying the top seats in the major world central banks may yet orchestrate a successful exit from the most massive monetary policy experiment in history.  On the other hand, a successful exit is far from certain, and initial reactions from stock and bond markets around the world certainly don’t reflect confidence in such an outcome.  Maintaining large, essentially fixed allocations to either stocks or bonds in this uncertain environment is to invite serious losses should an exit from the great monetary experiment prove less than successful.

Especially after extended market rallies, it’s important to recognize that what investors get to keep is what’s left in portfolios at market bottoms, not market tops.  The key to success is not to give back any appreciable amount during significant market declines.

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