2010May9 Week In Review

The week past certainly had its share of turmoil from riots in Greece to “The Crash of 2:45.” Unlike prior bubbles, this one was seemingly not caused by “Fools Rushing In.”  It will be some time before we know what precipitated Thursday afternoon’s free fall. Representatives of the exchanges have made statements that no error occurred with their technology.

 

"Character is Destiny."   This comes up a lot when someone makes a mistake and can't own up to it. Wall Street has had it character continuously maligned since 2008. How long will we wait for its true character to be shown? We don’t know.

 

Problems on Thursday afternoon had been preceded by a declining trend which caused us to start selling positions on Tuesday with more on Wednesday. Early Thursday trading was a global continuation of shifting market control from buyers to sellers. Unable to see the future and reaching loss limit thresholds; our discipline requires watching the dust settle from the sidelines rather than trying to stay in the game.

 

System overload occurred late in the trading day when the rules do not allow for a temporary shut down. Internet access to Google, Yahoo, Schwab and E-Trade was not even possible. Proctor & Gamble was severely mispriced while Accenture fell to a penny along with many other securities. Friday’s trading was less severe but still continued domination by sellers over buyers.

 

The weakening in foreign markets accelerated sufficiently this week to remove international positions from our primary asset allocation model. We expect major asset classes to persist from three months to more than a year. However, during market transitions, both value and relative strength disciplines can lag the market.

 

With some abnormally short allocation periods, does it make it hard to stay with the signals and feel like you’re zigging when you should be zagging? Yes, in the very short term we can feel out of sync. That’s uncomfortable and no one likes to be uncomfortable.

 

From the first moment a baby is born, you clearly know when they are uncomfortable. Babies cry if they are too hot or too cold; if they are hungry; if they’ve been over stimulated, or if they have a wet diaper. They cry to get our immediate attention that they are uncomfortable and as parents our responsibility is to make that discomfort go away. As an advisor, clients often voice their discomfort as often as a new born baby. All it takes is a headline on a newspaper or website, a flick of the remote and catching a segment on CNBC or a monthly statement to feel uncomfortable in the short term.

 

Any exercise program is going to make you uncomfortable whether it be pushing yourself on the elliptical for that extra ten minutes or adding those extra ten pounds to the weights. That discomfort in the short term means you ultimately get stronger.

 

The data we are buying and the discipline we use to apply it to portfolios has demonstrated two strong benefits. The first we have demonstrated on our web site in the 401k section where every plan participant would have had information allowing them to switch to a defensive strategy in 2008. Using the various asset choices of more than two dozen plans, active reallocation would have preserved portfolio values.

 

The second benefit is in the same data and has been an absolute refutation of the industry’s mantra: “You’ll miss the best day of the recovery if you go to cash.” That salesman’s mantra always omits how much more you will have if you avoided the decline that precedes the “best day.” In every case we have examined, the shift in risk and opportunity was identified signaling time to change to an offensive strategy. We continue to update this analytical work.

 

The culmination of our research was a decision to terminate relationships with institutional managers and take direct responsibility for client accounts. Institutional models are not designed to protect individual clients’ net worth. Unlike institutional and modern portfolio models, we use cash as an asset class to be held when other choices are in negative trends.

 

Recent client inquiries have been in two groups. One group is “cash is okay. I like the up elevator.” The other group is “why did you sell and take a loss? If we wait, won’t it go back up?” The reality is we do not know that. The future is unknown. Trends change. We know that. We want to know how many floors down the elevator is going. We just don’t want to ride it down to find out.

 

Since the October 2008 market decline, the underpinnings of modern portfolio theory have been severely challenged. Recently, in the Financial Analysts Journal, Roger Ibbotson called the foundational research about asset allocation “folklore.” Richard Thaler has challenged the rationality of markets and written that prices are not always “right.” More information about the problems of modern portfolio theory and its misapplication to asset allocation are on our web site. We recommend “The Myth of the Rational Market” by Justin Fox as an interesting and easy read.

 

 

For recipients who are not clients, we offer a free portfolio analysis. Call us for more information about what we may do to help your portfolio.