UnThreaded | Threaded | Whole Thread (14) | Ignore Thread Prev | Next
Author: WatchingTheHerd Big red star, 1000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 461078  
Subject: Portfolio Strategy in a Global Down Draft Date: 9/14/2008 8:20 PM
Post New | Post Reply | Reply Later | Create Poll . Report this Post | Recommend it!
Recommendations: 27
(also posted at: http://watchingtheherd.blogspot.com/2008/09/portfolio-strate... )

The number and size of the recent failures in the financial industry (from Bear Stearns, IndyMac, Fannie and Freddie and now, apparently, Lehman Brothers and Merrill Lynch) are causing millions of investors to review their investments and try to find a way to protect their assets from future turmoil and losses. A lot of the thinking likely began during the first credit freeze-up in August of 2007 but the worldwide nature of the problem requires rethinking many truisms of portfolio management that might have been useful in the past but may have limited value in the current situation.

A Triangle Model of Investments

Traditional strategies for investing are based upon long-observed patterns of performance with assets in three key categories. Each category can exhibit movement (and hence, provide opportunity for making / losing money) independently of what happens in the others but they also frequently move in patterns related to each other which have encouraged certain strategies by investors based upon their goals (growth versus safety) and horizon (long term versus near term).

Stocks -- Investments in stocks are based upon obtaining mid- to long-term gains in the price of the stocks based upon long term growth in a company's earnings or based upon speculation of short-term mistakes in other investors' current valuation of the company. The truism with stocks is that over a long term period (NOT just one or two business cycles), a well-diversified portfolio managed to proactively cull out losers will outperform virtually any other category of investment. Another truism is that stocks should be avoided by investors with capital preservation goals over a short time horizon, especially when economic growth slows or declines outright since slow/no growth cuts earnings and drives stock prices down.

Bonds -- Investments in bonds produce profit directly for the bondholder by interest paid back to the bondholder by the issuer at maturity. Because the actual value of promises of future, fixed payments of principle and interest are DIRECTLY dependent upon changes in real (or imagined) interest rates, the price of bonds at any given moment not only reflect the credit worthiness of the borrower but reflect larger estimates of changes in interest rates over the life of the bonds. One key truism with bonds is that accurately rated bonds pose significantly less risk over short periods than stocks and are therefore a more suitable investment vehicle for investors with short term horizons whose tolerance for risk is lower than those investing with a 15-20 year horizon.

Commodities -- Commodities act as the raw materials to higher level products and services and provide two avenues by which investors can profit. By their nature, many commodities such as wheat, rice, pork bellies, oil, natural gas, etc. can have regular, seasonal fluctuations in their supply, demand or both, requiring producers and consumers to constantly make bets on those numbers and their impact on their ability to fill next week's orders of widgets. This short term speculation is virtually required in a modern economy and has profit potential for those with nerves of steel. Because of commodities' perceived role as required inputs for an economy (albeit with some seasonal fluctuation), investors often use commodity investments as a hedge against currency concerns. The idea behind this is that no matter what a government may do to devalue its currency through monetary policy, a barrel of oil or a bushel of wheat is "worth" what we get out of a barrel of oil or bushel of wheat and therefore, in theory, if a currency declines in value by half, any commodity position denominated in that currency will double, protecting the investment. The key truism for commodities is that overall demand for commodities may fluctuate week to week or month to month but is predictable and steady over many months / years. In other words, demand for commodities is nearly independent of the long term performance of one or both of the other investment categories.


Trade-offs In the Triangle

Much of the established wisdom of portfolio management for individuals and institutions revolves around correctly understanding why each of these corners of the triangle traditionally behaves the way it does and how problems with one corner affect the other two. For example,

1) fears in the stock market will lead many short-term investors to shift funds to lower-yield but higher-safety bonds, raising prices in the bond market, lowering interest rates
2) fears of weak economic growth or actual reductions in economic output often lead the Federal Reserve to lower interest rates to reduce the cost of borrowing to spur the economy, raising bond prices
3) signs of stable earnings growth increase valuations on stocks, attracting more investors into stocks and lowering demand for bonds, reducing their price and causing borrowers who DO need to borrow money to pay higher interest rates to attract lenders
4) volatility in credit markets combined with weak growth or losses in equities can trigger increases in commodities prices as investors assume steady demand for commodities will protect against currency declines resulting from inflation

The obvious assumption behind this financial triangle concept is that the primary source of uncertainty in the system is the inability of the players involved to correctly forecast performance of the system down to the nearest billion (mere rounding errors in a multi-trillion economy) in the immediate term. These short term errors cause the system to go through the normal undershoot / overshoot oscillations of the business cycle but they are systematically identified by properly functioning accounting and risk management systems and acted upon. The events since August 2007 prove this assumption is absolutely no longer holding true. Banks have been caught holding commercial paper rated AAA until the day they sold at 25 percent of face value. Banks not even on the FDIC watch list have capsized and disappeared under the water with little notice.

The larger but more subtle problem with the triangle model is the assumption that at least one investment segment --- equities, bonds or commodities --- would retain a negative correlation to the others and provide a mechanism for hedging risk due to financial / monetary problems within an economy is likely untrue. The theory doesn't account for a global economy in which systemic failures in one economy produce systemic failures in other economies at the same time. Global trade requires currencies in different economies to become a commodity for other economies to facilitate trade OR requires many economies to consciously hold a subset of currencies as a de facto world currency for transactions.

Regardless of which approach is chosen, either one immediately links the "triangles" at not only the commodity corner but the bond / credit corner as well. If a systemic problem is encountered in the bond / credit sector of one of the economies, it can immediately affect the bond / credit sector of other economies. That in turn violates the assumption of larger world markets for commodities remaining stable / predictable over the long term as economic growth in multiple economies slows due to "contagion" in the financial sector. The net result is that the interconnected financial markets create POSITIVE correlations between all three corners of a particular economy and can create POSITIVE correlations BETWEEN economies. This might be good when things are going well in the short term but poses tremendous concerns when trouble arises.

Stated in the simplest terms, the triangle concept works as long as at least ONE corner of the triangle has a strong negative correlation to the performance of the other two corners. If the stocks and bonds corners are performing poorly, an investor can still shift money to commodities and ride that up as the other two corners go down until they stabilize. If larger problems crop up in all the triangles and reduce economic growth and demand for commodities, suddenly ALL THREE corners have a positive correlation to each other, leaving investors with no where to flee to protect their investments.

The concern facing all investors now is that this is precisely the situation we face. Gross mismanagement and outright fraud in the American housing market and financial industry have propagated trillions of dollars worth of bad debt to banks throughout the world. Any economy in the global system that attempts to shun more of the bad paper at the root of the problem will trigger a collapse in its local credit markets which already carry vast amounts of that bad paper. Any such credit meltdown will likely shrink economic output, weakening its equities and reduce demand for commodities, further increasing the positive correlation in all of the economic triangles.

So what's the best strategy for protecting one's portfolio? In a global economy linked by credit systems which have poisoned the fiat money of nearly all the players at the same time, it isn't clear there IS a winning strategy. The only way to win is to not play and that option doesn't exist.


WTH
Post New | Post Reply | Reply Later | Create Poll . Report this Post | Recommend it!
Print the post  
UnThreaded | Threaded | Whole Thread (14) | Ignore Thread Prev | Next

Announcements

Pencils of Promise - Back to School Drive
"Pencils of Promise works with communities across the globe to build schools and create programs that provide education opportunities for children."
Post of the Day:
Value Hounds

Netflix Riles Investors
What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Community Home
Speak Your Mind, Start Your Blog, Rate Your Stocks

Community Team Fools - who are those TMF's?
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and "#1 Media Company to Work For" (BusinessInsider 2011)! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.
Advertisement