The New Normal

The New Normal

In a recent speech Bill Gross of PIMCO outlined what his firm has termed the "New Normal." In a world of more regulation, private-sector deleveraging and less consumption, "it's hard for PIMCO to imagine" the Dow Jones Industrial Average/quotes/comstock/10w!i:dji/delayed climbing back to 14,000 or home prices returning to 2006 levels, growth will be stunted," he said. "It will be a different type of world and we have to get used to that."

“The U.S. economy will grow at between 1 and 2 percent a year rather than 2 to 3 percent a year for the next three to five years at least, that will make a significant difference for corporate profit growth," he said. Moreover, unemployment will hover around 7 to 8 percent rather than the recently typical 4 to 5 percent, he added, and the higher rate would be around "for a long time to come." Gross added that inflation would also start to accelerate in the near future.

This “New Normal” economic climate prompts investment advisors to question many previously held assumptions -- especially about whether stocks will outperform bonds, and what this means for their portfolios. Data shows that over certain time cycles, bonds have outperformed stocks.
Many experts have been pointing out how great U.S. government bonds have done the past 30 years – which they have - but in our view at RKM it's nearly mathematically impossible for bonds to do that again, based on current yields. The future can't be like the past; in fact it might be a mirror image – that is a reversed image.

We are convinced that equities now are priced more attractively. Government bond yields coupled with the looming threat of inflation - the curse of fixed-income investors - as the government prints money to combat the financial crisis provides more ammunition for this case.

What about the Banks? Financial engineering had supplanted real engineering in cities like London and New York and whole economies (Iceland) became dominated by the fast growing financial services industry. In the US, financial services’ share of total corporate profits increased from 10 percent in the early 1980’s to 40 percent in 2007! The stock market value of financial services firms increased from 6 percent in the early 1980’s to 23 percent in 2007! Why didn’t they see this crisis coming?

Relying on financial innovation has proved disastrous - think 80’s S&L crisis, 90’s international banking and LTCM crisis and the debacle we are still living. In “A Short History of Financial Euphoria,” economist John Kenneth Galbraith noted that: "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version." At this point we recommend avoiding bank stocks and bank sector mutual funds until the smoke clears.

What to do
Maintaining your wealth in the future will require strategies that reflect this changed vision of global economic growth. Bond investors should confine purchases to shorter maturities where price protection is more probable and as inflation increases, cash from maturing notes can be reinvested at higher rates. Investors may experience lower rates of return than what they grew accustomed to until 2008. Returns are the result of an economic environment.
In light of this “new normal” reality, investors should look for stable income from a portion of their investments, rather than reaching for returns. Short-term bond ladders and income paying stocks are two good examples.

Also, there is a chance that the dollar will lose its reserve status. The U.S. simply has too much debt. To be ready for that day, investors should invest outside the U.S., in faster growth economies. In particular, the BRIC countries - Brazil, Russia, India and China, for instance, consumption in China is 35 percent of GDP compared to nearly 70 percent in the U.S.- that shows huge growth potential.

PIMCO’s co-CIO’s Gross and El-Erian sum things up succinctly with the following half dozen sentences. “For the next 3–5 years, we expect a world of muted growth, in the context of a continuing shift away from the G-3 [U.S., Japan and Europe] and toward the systemically important emerging economies, led by China. It is a world where the public sector overstays as a provider of goods that belong in the private sector.”

“The banking system will be a shadow of its former self. With regulation more expansive in form and reach, the sector will be de-risked, de-levered, and subject to greater burden sharing. The forces of consolidation and shrinkage will spread beyond banks, impacting a host of non-bank financial institutions as well as the investment management industry.”

“In the next few years, the historical pace of growth in potential output will face many headwinds. Excessive regulation, higher taxation, and government intervention will be among the factors that will constrain the growth.”

If the above holds true and you are paying your advisor 2 or 3 percent in total fees your portfolio may suffer needlessly, therefore think about lowering your costs. As John Bogle was recently quoted saying, “A financial system that takes too much out of investor returns doesn't create additional value. We want to beat the market but will inevitably fail because of [transaction] costs, so I question our values and what is really enough.”


Chris Blakely, June 2009

Sources: PIMCO, Bloomberg LP, JK Galbraith, John Bogle, Morningstar, Marketwatch.com, NBER

Portfolio Management: Focus on the Future

Failures in Conventional Thinking

As we near the end of the first decade of the new millennium there are several new terms we use that rarely appeared in common conversation just 10 years ago, terms such as GPS, MP3, Blog, Plasma TV, Subprime and Stem Cells to name a few. All around our society, information describing our world expands at daunting rates and this explosion requires advancing analytics to make sense of it all. For most of the investment advisory business, portfolio building techniques and analyses sit in a conventional state lacking in thinking adapted to the world we know today.

Synonyms for diversification are words such as assortment, divergence, variety, and potpourri. In the in vestment business though, diversification has a very specific meaning: “A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.”

The notion of this specific diversification definition shows up on a wide variety of advisory websites under common concepts such as ”reduce the fluctuations”, “moving in the opposite direction”,” least amount of fluctuation”, “reduce the overall variability”, and smooth out the ups and downs.”

Truly, combining one asset class in the top quartile of the correlation continuum and one in the bottom quartile will smooth returns. However execution of this concept fails theory. Over time, asset classes have become highly correlated mathematically, defined as the top quartile in the correlation continuum – or correlation values of 0.5 to perfect correlation of 1.0.

Consider these facts:
* There are over 300 benchmarks correlated to the S&P 500 and average correlations have increased from 0.38 in 1996 to 0.63 in 2008 – an average solidly in the top quartile where little diversification exists.
* Bonds which used to be uncorrelated to U.S. stocks have moved from a negative correlation (-0.77) during the period from 1997-2002 to a positive correlation (0.68) during the time period 2002-2007.
* Corporate bonds which were clearly not correlated to all stocks10 years ago moved from -0.686 to a positive correlation over the last five years of 0.203.

Many investors have noticed the increased correlations of the capital markets. In a recent study of wealthy investors by PNC, the following quote appeared:
“The ultra wealthy likely are looking longer term, knowing that historically the stock market has advanced when interest rates are falling.”

Actually, investment theory says that a market that is good for bonds (falling interest rates due to recessionary pressure) is bad for stocks. In recent years though, it’s clear that the stock market benefits with interest rate declines and suffers with interest rate increases - to cool down an overheating economy. We also can see in the newspapers that global markets are highly integrated with our markets, reflected in a correlation of the MSCI EAFE (Europe, Australasia, and the Far East) index to the S&P 500 of 0.9 – remember 1.0 is perfectly correlated!

What we end up with is a portfolio built with the presumption of return diversification – smoothing returns over time – but in reality, a portfolio that delivers little real benefit.
Many advisors are quick to show reduced return and volatility factors using a mixture of asset classes. This is a bit of investment sleight of hand. Correlations reflect patterns of returns, the ups and downs of the market as shown in the chart below. High correlations between investments do not mean the actual returns are the same, just the pattern of returns. That does not mean investment diversification has been achieved. Think of it this way, varying the ingredients will make cakes look and taste different, but, in the end, you still have cake!

The world is flat and correlated
A successful portfolio funds your future needs or liabilities; anything short of this is a failure. It makes sense, then, that the portfolio must handle future events, not those of the past. Investment analysis uses past returns as the essential data for risk and return statistics. Consequently, the advisory business puts too much emphasis on past returns of funds and managers, when in fact it is subordinate.
Returns are the result of an economic environment. An economic environment has vast numbers of variables that play out in unpredictable ways, to this point, would anyone dispute that a single industry (banks) can alter an economy? A portfolio defined today must play out in the uncertainty that is the future.
Proper diversification weights the portfolio toward asset classes with the strength to handle the future.

Chris Blakely - May 2009

Sources: Dictionary.com, Investopedia.com, Bloomberg L.P., Investment News (12/14/2007)