Synchronicity and the Modern Portfolio Theory

(September 2008) One of the key tenets of Modern Portfolio Theory (MPT) holds that diversification among asset classes is one of the most important ways for an investor to both moderate his risk and enhance his prospects for above-average performance over time. Thus, over the years, investors have scrambled to find asset classes which generated returns that were not correlated (similar) to one another.

The theory here is, with a widely diversified portfolio, investors ensure capturing the above-average returns of hot asset classes in exchange for also being exposed to under-performers. To use a baseball analogy, you never really hit a home run, but you also don’t foul out. You get on base, and being on base is the only way to consistently score. Since no one has a crystal ball as to which asset class is going to outperform over an ensuing time period, broad-based diversification is the only way to ensure optimal exposure to the next hot market segment. The fact that you also have to be exposed to the lagging segment as well is an acceptable tradeoff, for the data supports that this approach will out-perform less diversified options over time.

However, over the past few months, investors are getting a rude lesson in the fact that diversification — while a legitimate risk attenuation mechanism — is not always able to shield a portfolio from negative returns. Just looking at equity returns for 2008, there are virtually no markets that are doing well. While most major domestic stock indices are firmly in the red for the year, overseas returns have been even worse. Chinese stocks, once the darling of international investors and with the country still basking in waning Olympic limelight, have turned in an abysmal year. Now that the Beijing Games are history, it is unlikely that there is any news in China that will attract the attention of international investors any time over the balance of the year. Chinese investors, still reeling from losses that they were unaccustomed to experiencing, are also showing reluctance to wade back in.

Over the past few years, the BRIC countries (Brazil, Russia, India, and China) had seen dramatic economic growth and ebullient stock market returns. However, the bloom is off the bud as the Russell BRIC index is off 32.4% year-to-date. The Russian market and currency (ruble) have been in virtual free-fall since Russia’s invasion and occupation of parts of Georgia last month. Investors are wise to recognize that Russia’s new-found assertiveness and blatant disregard for international law and public opinion does not bode well for owners of Russian assets going forward.

India, too, is enduring a rough economic period as its export-dependant economy slows in reaction to slackening global demand. Even Brazil, with less exposure to high oil prices, has seen stock returns turn negative.

In the U.S., for the year to date, large-cap growth stocks have outperformed large-cap value, but small caps have actually done considerably better than large caps, with small-cap value outperforming small-cap growth. However, all domestic equity indexes are in the red for 2008.

Commodities, which only months ago where trading as if they were no longer subject to gravity, are now coming back to earth with reckless abandon. Gold, oil, wheat, corn, etc. are all in bear market territory, leaving many a mangled hedge fund in their wake.

How about real estate? Let’s not go there! Indeed, it has been the bursting of the real estate bubble (both in the U.S. and other parts of the world (such as Britain)) that set the stage for the rough economic situation in which we now find ourselves.

U.S. Treasury debt and the dollar are the only two assets which are holding up reasonably well in this environment but, after adjusting for inflation, yields on Treasuries are also modestly negative.

One could certainly argue that short-sellers are making money, but the truth is, anyone who is 100% short every conceivable market right now is exposed to risk at a level that would be unacceptable to the average investor. People who have benefited from the returns on short (or market inverse) positions are more than likely holding a traditional, broadly diversified portfolio, where the short (or inverse) position is merely a hedge, not the dominant position.

At least at this point in time, we appear to be in a globally synchronous bear market. There is almost nothing that is working for investors. Cash is certainly king right now, but even cash has its problems. With bank failures becoming a frequent problem, investors no longer can take the safety of money invested in cash equivalents to be bulletproof. Depositors need to be especially cautious, so as to avoid having assets over the FDIC insurance limit at virtually any institution — no matter how big it might be or how reassuring its commercials might sound. Money market fund prospectuses should be scoured to ensure that the manager is not exposed to repurchase agreements or commercial paper from entities whose financial health is tenuous. And once a solid and dependable cash alternative is found, you will probably find that its inflation-adjusted yield is paltry.

This synchronous bear market has some worried about the specter of deflation — not inflation — going forward. Deflation — normally associated with economic depressions — is not something to be taken lightly.

The wealth being destroyed in this current investment climate is significant. Today’s grim employment numbers point to an economy that is on the brink of recession. We also face political uncertainty, as the 2008 election enters the home stretch. The choice between competing tax and economic policies could not be more stark and the U.S. market will begin to discount in an anticipated political outcome in the weeks ahead.

At Ockham, we believe that bear markets uncover value. While no one likes enduring losses, they are part of the investment game. The stocks of many high-quality domestic companies have been in a bear market for almost a decade. General Electric, Home Depot, and Coca-Cola to name a few, are all trading well below highs reached over ten years ago. These companies have continued to sustain solid earnings growth for the most part, so that once lofty multiples have been compressed to more attractive levels. We would advise that investors be prepared to put money to work in the months ahead in quality domestic equities. Despite the doom and gloom that is daily fare in the mainstream press, economic contractions do eventually end and global growth will return. When that day comes, U.S. companies will be well positioned to compete.

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(09/11/08)