No need to worry!

I recently came upon an article entitled “What You Can Do About The Upcoming Stock Market Crash”.  The title was tongue in cheek and perhaps unfortunately so given recent events.  Nevertheless, it made a number of important points about the difficulty of knowing when a market is at its peak and when a market is at its lows, and of knowing in which direction and by how much a market is going to move at any given point in time.  Much of this I agreed with, but not all:

When you think about it that risk and fear will always be there no matter how far the market goes up, down, or sideways. So what can you do?

Be prepared for a crash at any time. If you need to withdraw money in the next few years or you want to cushion the blows, then you need to diversify your portfolio with enough bonds, cash, or other assets that won’t fall along with the stock market.

Once you figure out what is right for your current situation you don’t have to worry about what happens because you are controlling the risks instead of letting them control you. That means you are safe to invest your money today and start earning your way to the freedom you want for yourself and your family.

Points 1 and 2 noted above are more or less correct, but the last point I have emboldened is where I diverge.  You are never ”controlling” risk, just diversifying it relative to return, and if possible, its covariance, itself a function of risk.  You cannot control risk, only minimise its impact through structure.  You are certainly not safe to invest your money today and there is no guarantee that you will earn your way to freedom. 

Return is an important consideration when accepting risk and many today who use simple mean variance models assume that expected returns are invariant and that risk is only volatility around this return.  In a general equilibrium, random, independent price movement model it does not pay on average to delay or defer investment (any benefit is purely attained by chance), but even here you are hostage to the probability distribution since the expected return in Monte Carlo land is only the average of many outcomes, some of which turn out to be quite disastrous from any level.

But expected returns do matter and while timing your investment to maximise your returns and minimise your losses is impractical and impossible for the market as a whole to do, making value judgements about market valuations and economic cycles to inform you of the boundaries of return and its significance is I believe worthwhile if you possess the expertise..  Where people run into trouble is where they either lack the knowledge and expertise to make the type of judgements needed to define the boundaries of expected return, and its impact on structure, as markets and economic cycles mature or react to market falls and meteoric rises as if one is the end of the world and the other its never ending bliss.

Deferring new risky investment at high market valuations is a value call and a discipline, but it is an act which relies on knowledge of the significance of valuation differentials.  It is one of my concerns that “we” have been taught that we should invest in markets at all times irrespective of the valuation, the cycle and the specific characteristics of either.  One of the reasons the world has been through innumerable crises since the late 1990s is because we have ignored significant accumulating structural economic and financial imbalances and the differential between asset valuations and economic fundamentals.  In a well balanced world we could probably ignore valuations and invest at will, ignoring volatility. 

But then again context is everything.  While one may not invest/sell at cyclical highs/lows there is little reason to sell all (high) and then attempt to reinvest all (lows) at perceived key turning points.  Portfolios should adjust to the relationship between valuation risks and the time frame of their liability profiles and it is here where we need to pay attention to valuation risks since these do have material impact.   As markets rise returns fall and the risks to the ability of assets to meet future needs increases, and vice versa.  When returns and risks pass barriers of significance that is where changes at the margin need to be made.  It is therefore not a question of timing but of tangible discipline and its benchmarks.

And, of course, I believe we are in the middle of a very long period of global economic and financial fragility, so safe is a word I would eschew for some time.

A brief thought on market valuations

As I work my way back into the mental state required to hold the data points I just wanted to make one key point.   Many have commented on the pointlessness of market timing and therefore the pointlessness of listening to those who believe that a large negative market movement is around the corner.  I have never been one for wholesale market timing transactions, but I do believe that high market valuations impact one critical dimension of the portfolio and need to be treated with respect.   The higher a market is valued, in an out of equilibrium world, the lower the future expected returns.  Therefore, without an adjustment for future returns the liability demands  on the portfolio (which have likely been revised higher due to higher portfolio values) will place undue and increasing stress on the portfolio’s ability to meet those returns, especially in the event of an eventual market adjustment.   As markets rise and as the time frame of significant market risk extends, for a given level of liabilities, it makes sense to adjust asset allocation towards lower risk/fixed return asset classes.   We cannot ignore valuations and we cannot ignore their impact on the management of income and capital liabilities over time.    

Russian Roulette– more data

Leverage strategies using high cost retail investment products expose investors to significant risks, especially at fair to high market valuations.   Even very low cost strategies are exposed to significant risk as the market and economic cycle matures strongly suggesting that leverage is more strategic than a long term asset allocation play.  

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What is investment risk?

“What is investment risk” is both simple and complex and in order to assess the information needed to assess risk we first of all need to qualify the world view of risk and return and then the model we are using to manage the risks and their impact. All this is beyond the subject matter expertise of the individual investor and why point of sale documentation can only ever inform about the broad nature of risk and return but never be sufficient to allow the investor to fully own the decision. Ownership of the transaction decision resides with ownership of the process and the significance of risk assumed with respect to risk via structure, assumptions and costs.

At a very basic level, risk is what happens to a price between two points in time and the impact of that movement in price – it can be both positive and negative.  But what gives rise to risk is more important than a mere list of risk factors, or indeed a narrow quantitative measure of risk.

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Is Syria the catalyst?

Markets have advanced quite well over the year and margin debt has scaled new highs.  The Fed looks as if it is close to scaling back its QE and the uncertainty over the impact of this on asset prices has been making minor waves.  The Syrian issue has impacted the market today, and while it is impossible to forecast any economic or financial impact of an escalation, because this really is an unknown entity, the real question is to what extent will the Syrian variable in the equation influence short term money, that may have been mulling other factors, to pull out now.   

Asset allocation in a financial crisis..

Portfolios with liability demands need to be run along liability tracks with a greater sensitivity towards a) liability risks in terms of benchmark allocations to risky assets and allowed for deviations from those benchmarks and b) cyclical market and economic risks and especially significant structural risks that could materially impact returns on risky assets.  

It is more what portfolios do in terms of adjusting allocations given liabilities profiles as risky asset prices inflate, than what portfolios can and cannot do in a risk event when asset price declines have pre-empted any possible move.

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When beta is wrong…and by implication expected return, risk and covariance..

One of my many issues with modern portfolio theory is that it assumes not only that markets clear but that supply and demand are also optimal.

In a low growth environment where asset prices are being pushed upwards through quantitative easing, modern portfolio theory tenets becoming increasingly irrelevant for efficient asset allocation in risk return space and a serious risk to effective withdrawal management.  In such an environment we have to be very careful in our assessment of beta and the risks both allocating to and away from it present.  

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On market timing… Part 5: Linear dynamics of excess money supply growth.

Let us assume that nominal economic growth is say 5% (real 3%), and money supply growth is 8%, money stock is $20 and the asset allocation component of money supply starts at 50% of the stock of broad money. The asset allocation component starts at $10. If nominal GDP growth is 5%, then return on equities would be 5% plus dividends. With a 3% excess money supply growth, the growth rate of asset focused money supply is 11% or 220% of nominal economic growth; this annual rate of excess money supply growth is similar to average excess broad money supply growth in the US from 1995, based on the data in chart 7.

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On market timing… Part 4: Transitional dynamics of Saving and Dissaving.

What makes more sense than selling when everybody else is selling? Selling assets while the demand (money flow) for those assets is still strong; a liability imperative should force investors to sell higher risk investments at fair to high absolute market valuations and avoid selling at low valuations.

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On market timing… Part 1: Point in Time Market Timing.

A recent Dan Solin article opined “Don’t try to time the market by bouncing in and out of stocks and bonds.”

This reminded me of a detailed market timing analysis I provided in my 2008 Capitalism in Crisis 3 report.   I am breaking this analysis down into a number of parts as follows:

In practical terms, market timing per se is a marginal investment activity. This does not mean that investors should not be engaged in some form of structured adjustment to asset allocation during periods of market excess, or that risk and hence valuations do not move to extremes; this document does not believe that markets can efficiently price risk at all points of the market and economic cycle, for a number of reasons. There is also a big difference between arbitrage, market timing and structured adjustment to asset allocations based on liability profile (the economic imperative); arbitrage and structured adjustment are both valid and necessary.

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