Posts Tagged ‘Diversification’
Monday, February 25th, 2013
Fed Leaves Punchbowl, Takes Away Free Lunch (of International Diversification)
The growing importance of country selection
William Hester, CFA
A quiet but important development in global investing over the last few years has been the shift in the relationship between US markets and other global benchmarks. It’s widely known that correlations have been rising over the last few decades. Less discussed though is the shift in the changing sensitivity of international stocks versus US benchmarks. Both of these changing relationships are turning decades of global diversification arguments on their head.
Diversification into international equity markets by US investors has relied on one constant benefit: better portfolio risk attributes. Higher returns were also sometimes achieved by US investors – but they were time dependent. During the 15-year period through 1985, international stocks would have boosted the returns of a diversified portfolio versus a portfolio allocated to only US stocks. But during the next 15-year period international stocks would have instead weighed on the performance of a diversified portfolio. The constant benefit of international equity diversification has been the lower risk experienced by portfolios that combine domestic and international markets.
These risk attributes were the result of low correlations and low betas between broad global benchmarks and the US markets. During the 1980’s the correlation between MSCI’s EASEA Index (this index tracks the performance of countries in MSCI’s EAFE Index without the effects of Japan) and MSCI’s US Index was about .5. Over the last decade it’s been .8. And, recently, because the volatility of international markets has increased in relation to US markets, along with rising correlations, the beta of global markets relative to US markets has jumped by an even greater extent. The best way to think about the performance of international stocks over the last few years is as high beta investments relative to the US market. The graph below shows the rolling 5-year beta between MSCI’s EASEA Index and MSCI’s US Index. It’s clear that there has been a substantial shift in the beta of international benchmarks versus the US since the beginning of last decade.
A look into what’s driving this change in sensitivity highlights some interesting and potentially unexpected relationships. Specifically, we can ask whether the higher beta of international stocks relative to domestic stocks has come during periods of rising or falling markets. It’s generally well known that during stock market declines, correlations among global markets rise, which will typically boost betas. (One way to define beta, in this context, is: Correlation of International and US Benchmark * [Standard Deviation of International Benchmark / Standard Deviation of US Benchmark]. So even with constant levels of volatility, higher correlations will boost the beta between benchmarks). And the beta of international stocks has risen in down months in recent years.
What’s been making a larger impact more recently, though, is the sensitivity of global markets during periods when US markets are rising. The graph below shows the rolling 5-year beta during periods when the US market is rising (in green) and when it’s falling (red).
The graph above suggests that the beta between international and US benchmarks has recently risen in both advancing and declining markets. But the larger contributor to the overall recent increase in beta has occurred during periods when the US market is advancing.
Why is this? There are a number of explanations for the rising correlation and sensitivity between international and US markets. Economies are increasingly becoming more closely linked. As John Hussman recently pointed out, the correlation between GDP growth in most large developed countries and the US is high – typically between 70 and 90%. Plus, most developed countries are better valued than the US, based on their individual historical range of Cyclically-Adjusted PE ratios. (See An Update on International Markets Valuations. These trends remain in place.) So market advances in other developed countries are beginning from generally better levels of valuation than in the US, spurring greater gains.
But some of the recent shift in international beta can also be explained by the concert of central back easings around the world, forcing investors to make investments based on expected monetary policy rather than the individual economic and fundamental corporate performance of each country. Recent research out of the Federal Reserve supports the idea that the beacon that investors are drawn to in making these decisions is the Federal Reserve itself.
The FOMC Announcement Drift
In a widely quoted paper last year, David Lucca and Emanuel Moench of the Federal Reserve Bank of New York highlighted the performance of stocks during periods surrounding FOMC meetings. They found that since 1994, more than 80 percent of the return from stocks (above risk-free returns) during this period came from a small window of time around FOMC dates. In addition to making the connection between US stock market performance and FOMC dates, the researchers also studied the effects on international markets. There was broad agreement in the data that international markets – including the German DAX, FTSE 100, and the French CAC40 Index – also experienced a bulk of their gains in the days surrounding FOMC meetings. Japan – the last bastion of international diversification, for good or for worse – was the only major stock market index tested that didn’t show a significant FOMC meeting period return. Interestingly, international markets responded more significantly around FOMC meetings, than their own central bank meetings.
The graph below shows the role the Fed has exerted on both US and international markets. Ned Davis recently showed a similar chart to his clients that highlighted the performance of the S&P 500 both including and excluding the performance around FOMC meetings. In the chart below, I’ve added the performance of the EASEA index. The blue lines show how the US market has done including the days around FOMC dates (in light blue) and also the performance of the market with the days around the FOMC dates taken out of the calculation (in dark blue). The red lines show the performance of the EASEA including the days around the FOMC dates (in light red) and also the performance of the benchmark with the days around the FOMC dates taken out of the calculation (in dark red).
This graph tells a similar message as the earlier graphs. The beta of the EASEA index in relation to the US Index can be seen by the faster advances – and steeper declines. But also, the bulk of returns have occurred around FOMC meetings, just as they have in the US markets. In the case of the EASEA Index, the market is up 8 percent on a price basis since the peak of the market in 2000, but is down 19 percent if the days surrounding FOMC meetings aren’t included.
To recap, the secular rise in the correlation of global market returns continues, and the beta of international benchmarks relative to the US has been rising in both up and down markets – but the bulk of that rising sensitivity has occurred when the US market was advancing. And both US markets and international markets have netted the bulk of their advances around FOMC meetings. For investors seeking out the proverbial free lunch of international equity diversification – like returns with lower risk – this doesn’t sound like a favorable shift in trends. And it’s not.
Changing Risk Characteristics and International Diversification
The role of these changing characteristics in risk measures can be seen in the graph below. It shows portfolios of different combinations of US and EASEA benchmarks, over different periods. Each mark on each curve represents a 10 percent shift in portfolio holdings – from 100 percent of the portfolio in the US benchmark on one end of the line to 100 percent of the portfolio in the EASEA benchmark at the opposite end of the line. The blue curve represents the relationship between return and risk of holding these different portfolios from 1970 to 1985. The red curve covers 1985 to 2000. The green curve covers the time since 2000.
The different heights of the curves (measured by the vertical axis) capture the effects of secular bull and bear markets, and are less important to this analysis. What is important is how different the return and risk characteristics have been in the most recent period compared with history. Typically there has been a reduction in risk by adding EASEA exposure to a US portfolio. During the 1970 through 1985 period, the least risky portfolio was 17 percent less risky than the most volatile portfolio (in this case 100 percent invested in the EASEA Index). During the 1985 through 2000 period, portfolio risk could have been reduced by 11 percent. During the last 12 years, the portfolio results curve climbs upward left to right, implying that international stocks added some extra return, but they did so with much more risk. If these trends continue, many portfolios that were optimized by relying on outdated global stock market relationships could end up delivering poor results.
We can show the effects of these changing characteristics another way. As noted above, the one constant benefit of un-hedged international equity diversification has historically been lower portfolio risk. Better returns for US investors have come and gone, but for the bulk of the last 40 years, US portfolios diversified into global markets produced portfolios with lower amounts of risk. That benefit has disappeared. The graph below shows the difference in rolling 5-year standard deviations between a portfolio invested only in the MSCI US benchmark versus a portfolio invested 60 percent in the US and 40 percent in the EASEA index. The graph shows that outside a short period in the mid-1990’s a diversified portfolio always led to lower overall risk. Over the last couple of years, that is no longer the case. The portfolio risk of a diversified equity portfolio has been higher than a US domestic-focused portfolio.
None of this data argues against the benefits of international equity diversification over longer holding periods. The historical lessons Japan offers up on this are clear. The Nikkei Index remains 70 percent below its peak – for buy and hold investors it has been a catastrophically bad investment for more than 20 years. For most of the last two decades, it’s been a combination of periodic profit recessions and persistent price-multiple compression that has continually dragged down the country’s stock market performance. Japan’s history alone should convince investors of the unnecessary level of country-specific risk taken with an undiversified equity portfolio.
But now that faith in the Fed has gone global, it’s probably a good time to consider how long these trends will persist. Here are three trends or characteristics of historical data that are worth considering.
The FOMC Announcement Drift May Be Disappearing
The FOMC Announcement Drift may be about to join a long line of stock market anomalies that once discovered, almost immediately go missing. The graph below shows a 14-meeting moving average of the performance of both the MSCI US and MSCI EASEA Index in the three-day period surrounding FOMC meetings. The trend of strong daily returns can be seen through the middle of 2011, and then drops off noticeably. This may be in part because the Fed’s recent major QE announcements were leaked or slowly assumed into market prices over time, instead of first being announced at a FOMC meeting. But as John Hussman noted last week, the rallies that followed those QE announcements mostly just recovered market declines that had occurred over the preceding 6-month period.
Stock Market Declines & Correlations
There are two dynamics of correlation that are working against the diversification benefits of holding un-hedged international investments. The first is the secular rise in the levels of correlation – from 0.4 in the 1970’s, to a recent peak of 0.9 over rolling 6-month periods. The second is how correlations rise in lock-step with the amount of downside experienced in US markets. The graph below shows how markets tend to be more highly correlated the deeper the market drawdown. The horizontal axis shows the maximum drawdown in the US market over prior 12-month periods. The vertical axis shows the correlation of returns of MSCI’s US Index and and MSCI’s EASEA Index in those periods. It shows that as U.S. drawdowns deepen, the correlation among US and international stocks typically grows.
The rise in correlation and beta between global markets and the US essentially heightens the importance of the riskiness inherent in US markets. During moderate pull-backs, investors should expect moderate correlations among global markets. But the greater the risk of a potential large decline in the US market, the more risk there is for international markets as well, and the more likely it is that a larger numbers of countries will participate in further weakness.
US Recessions Matter Globally
Probably one of the most clearest features of international economic data is that individual country recessions tend to be shared globally. There are a few cases – Japan, clearly being one of them – where countries enter into recession without the company of other countries. But the majority of local recessions coincide with global recessions. The early 1970’s, early 1980’s, early 1990’s, and 2008 all represented global recessions.
With Japan, Spain, Italy and the UK are already in – or likely in – recession. The French economy has stopped expanding, and the most recent plunge in the French Purchasing Manager’s Index suggests an economic contraction over the next couple of quarters. The recent improvement in Germany’s PMI should be watched closely, as longer-term measures are pointing to continued deceleration in economic growth. And as more developed countries fall into recession, it becomes increasingly anomalous for the United States not to fall into recession.
If the US economy falls into recession this year, what would that mean for the majority of developed countries? Although there is a large amount of overlap among recessions, there are at least some periods where non-US countries fall into recession early, get stuck in a prolonged contraction, or in some cases, have an isolated recession. What is the average performance during these periods?
The graph below tries to put this into perspective. The vertical axis measures the average monthly performance of each country when neither that country nor the US economy is in recession. As you would expect, these average monthly returns are all positive. The horizontal axis in the graph also measures the average monthly performance, and separates the recession-linked performance of each country into two categories. The red points represent average returns when the local country is in a recession, but the US is not in recession. The blue points represent average returns when the US is in recession and the local country is not.
For example, consider the blue “DE” diamond and the red “DE” square. Both indicate that when neither the U.S. nor Germany has been in recession, German stocks have averaged returns of about 1.1% monthly. The blue square indicates that when the U.S. has been in recession and Germany has not, German stocks have still lost more than 1% monthly, on average. The red square indicates that when Germany has been in recession and the U.S. has not, German stocks have lost about -0.5% monthly.
Both set of points tell an interesting story. The red points highlight the fact that the majority of countries actually do modestly well even when their own economy is in recession – as long the US economy is still expanding. (This can be seen in recent data, as some European countries currently in recession booked gains last year). The blue data points suggest that the stock markets of most countries fall when the US economy is contracting – even if the local country is not in recession. This picks up on the strong correlation between international markets and the US market, even if local prospects are more favorable. It’s likely that if the US were to enter into a recession this year, international markets will be pressured downward regardless of their individual country economic conditions.
How should investor’s respond to the changing landscape of international investing? One solution would be to wait out the recent trends in the data, hoping for the free lunch of international diversification to return. That may be too risky a strategy. The bulk of these earlier trends seem unlikely to return because the rise in correlations among large developed international countries and US stocks has been secular in nature.
If correlations remain high among broad international indexes and the US markets, a more promising solution may be to begin to think about the investment potential and diversification characteristics of individual countries. This is likely where the next advances in the study of asset allocation will take place: gaining international exposure not through broad benchmarks, but instead through a subset of countries based on individual characteristics. There are a number of investment strategies that would have been successful over the last 40 years. Value-rotation strategies (for example, ranking countries by dividend yield) have historically offered up higher returns than the broad benchmarks. In our work, a focus on characteristics such as valuation, yield trends, market internals, and the quality of a of country’s balance sheet has shown to be a historically robust strategy.
On this topic, there’s actually good news – the potential benefits of individual country selection are increasing. One result of the adoption of the Euro was that country selection within a portfolio became less important (which is one reason why correlations have increased). With the exception of the late 1990’s stock market bubble, the spread between the best performing countries and the worst collapsed. Not surprisingly, this performance characteristic also tracked the relative risk taken in sovereign bonds. This made the process of individual country selection less rewarding.
Over the last few years as sovereign yield spreads have widened (until recently), so has the spread between the performance of the top and bottom-performing countries. The current spread has nearly doubled and it could continue to widen. In the 1980’s-1990’s, the spread between the best and worst performing countries was at times 50 percent higher than current levels. In the graph below, the red line shows the difference between the three top and bottom performing countries over rolling 3-year periods.
And it’s not only returns that can be boosted by effective country selection; portfolio risk attributes also tend to improve. The graph below shows the performance of countries relative to the US market over the past five years, in both up and down markets. You can see that the majority of markets have betas greater than one – in both rising and falling markets. But individual countries would have provided very different risk and return characteristics to a portfolio, versus a broad benchmark.
As major developed economies around the world become more intertwined, and as long as the Federal Reserve continues to devote its $3 trillion balance sheet to encourage stock market speculation, it seems likely that intermediate-term correlations will stay high, and the potential benefits of a simple, un-hedged international diversification strategy will come up short relative to its own history. A US recession, or steep decline in US markets, will almost certainly push those correlations even higher, at least temporarily. Seeking out countries – instead of broad indexes – that can subsequently offer portfolios favorable return and risk characteristics will likely end up being the strongest defense against the secular rise in the correlations of broad world equity benchmarks.
Copyright © Hussman Funds
Monday, July 30th, 2012
by William R. Benz, PIMCO
- For investors, the biggest challenge now is moving from a world of normal distributions, with expected occurrences around the mean, to one of bi-modal distributions where more extreme scenarios prevail.
- Key institutions, including governments and central banks, were previously stabilising forces but are now helping to accelerate underlying, destabilising trends in the global economy and financial markets.
- In this environment, investors need to invest for outcomes rather than simply for beta and diversification.
Perhaps the most important tradition at PIMCO is our annual Secular Forum in May. Since I joined 26 years ago and participated in my first forum with 16 other investment professionals, our forums have become much bigger and much more global. More than 300 of us descended on Newport Beach or tuned in via video in our most recent round. But the tradition continues, as does the intensity and excitement, with the output of our forum – our three- to five-year secular outlook – forming the cornerstone of both our longer-term investment strategy and our business positioning.
Mohamed El-Erian, our CEO and co-CIO, in his Secular Outlook commentary “Policy Confusions & Inflection Points,” summarized three themes that we expect to play out over the next few years: continued policy and political confusion, overly incremental public and private sector responses and, therefore, greater potential for inflection points. Mohamed also discussed the key investment implications of our outlook, noting that the strategies and guidelines that may have served investors in the past will likely be challenged in the context of inflection dynamics.
That point is worth revisiting and expanding upon because, in our view, investing is fundamentally changing. Previously, most investors simply aimed to beat their benchmarks and diversify among assets to mitigate risk. But today, as we face unusual uncertainty in the global economy and the financial markets, extreme events are not only possible but increasingly likely, and in this environment, we believe investors need to define their objectives and choose strategies that target specific outcomes.
Investors’ biggest challenge
The world is facing a number of very significant challenges for which there are no easy solutions. The eurozone faces high debt levels, a lack of structural growth and pressure to get the policy mix right to avoid contagion. The U.S. is suffering slow growth, high debt, a looming fiscal cliff and political polarisation. While enjoying higher relative growth, China and the developing world are also slowing and making difficult transitions from export-led to consumer-driven ‘emerged’ economies. And globally, a lack of policy coordination, increased income inequality and the growing use of social networks as communication tools also present long-term challenges.
Uncertainty is one common theme, and another is the potential for more extreme outcomes, good or bad. The eurozone, for instance, has to either find a path toward fiscal union or create a mechanism for orderly exit, with very little room to manoeuvre in between. Likewise, the U.S. needs to find a way to resolve its fiscal issues or face the consequences of a further downgrade and eventual loss of reserve currency status.
For investors, then, the biggest challenge is not continued volatility; that’s almost a given. The challenge is moving from a world of normal distributions, with expected occurrences around the mean, to one of bi-modal distributions where more extreme scenarios prevail.
Key institutions: once stabilisers, now accelerants
In the old normal, key institutions acted as stabilisers: They generally behaved in a counter-cyclical fashion to help enforce reversion to the mean. For example, governments and central banks enacted policies to stimulate growth and prevent deflation during economic downturns and did the opposite in upturns. Regulators tended to de-regulate during tough times and tighten the rules during times of excess, while financial institutions decreased and increased lending as interest rates rose and fell.
Their actions, individually and collectively, helped bring economic growth and the markets back to normal, back to long-term averages, back to the mean. They weren’t necessarily coordinated, but they were generally effective and helped create the Great Moderation of steady growth, strong returns and relatively low volatility that we witnessed from the mid-to-late 1980s until the global financial crisis in 2008.
But today, these institutions are acting as accelerants. Governments in Europe, the U.S. and Japan are under pressure to pursue fiscal austerity rather than stimulate growth, exacerbating the downturn. Central banks are largely going their own way, after a well-coordinated response to the financial crisis, and in some cases, are resisting stimulative measures, which is slowing, if not preventing, the healing process. Regulators, adopting a ‘never again’ mentality, are creating blunt instruments to solve complex problems, leading to unintended consequences, particularly in the banking sector, at a time when more rather than less lending should be the recommended medicine. And banks, especially in the eurozone, have been severely impacted by their holdings of sovereign debt, which, in turn, has led to a vicious cycle of falling share prices, credit rating downgrades, asset sales, reduced lending, slowing local economies, worsening government balance sheets and ultimately, an acceleration of, rather than a counterbalance to, the crisis.
Finally, investors are also acting as accelerants. Individual investors have always been more momentum-driven but had little aggregate impact on markets in the past due to their small size, lack of timely and direct access to information and lack of coordinated activity. But as they’ve grown in size and sophistication, accessing real-time information through their defined contribution plans, global platforms, multi-national distributors, private banks and independent financial advisors, their impact has become much more pronounced. When risk sectors outperform, flows into those sectors tend to increase; when they underperform, flows tend to diminish. In both cases, underlying trends are reinforced.
What’s even more interesting is how the behaviour of institutional investors has changed. This began in 2000-01, after the technology bubble burst. The perfect storm of plunging equity markets and falling interest rates turned corporate and public pension plan surpluses into deficits and created big challenges for foundations, endowments and others seeking income and targeting specific absolute returns. The movement toward solution-based investing was born as investors began to shift toward liability-driven investing (LDI), absolute return, income seeking and other, more specific strategies. The momentum increased following Lehman’s bankruptcy and again in response to recent events in Europe. But with this shift has come a more activist (or re-activist) approach, as investors make larger and more frequent changes to overall strategy, tactical weightings, benchmarks and guidelines. Some still prefer to rebalance around their longer-term, normal policy targets, but as a group – and we see this globally across our client base – institutional investors have indeed become more active.
Governments, central banks, regulators, financial institutions and investors – each group is responding to the challenges they are facing in a logical and well-intentioned fashion. Yet in the current secular environment, we believe their actions are adding to, rather than smoothing, volatility. And instead of acting as stabilising forces, we believe they are actually helping to accelerate the underlying destabilising trends. (See figure below.)
Significant implications for investors
Global challenges combined with these market accelerants have created an environment of unusual uncertainty in which ‘muddle-through’ is a temporary state. We believe this has significant implications for investors, particularly those who are still investing simply for beta and diversification rather than for specific outcomes.
First and foremost, the new normal is here, and investors need to embrace it. We coined the phrase a few years ago to describe a multi-speed world on a bumpy journey of deleveraging, reregulation and eventual reflation. We can argue whether we’re still on the journey or we’ve arrived at the final (though still very bumpy) destination. But what’s clear is that what felt like a ‘new’ normal back then now just feels normal. Gone are the days of the Great Moderation, reversion to the mean and normal-shaped distributions, in our view; instead, continued (high) volatility, acceleration in trends and bi-modal outcomes have become the new norm. In an era when muddle-through is no longer a viable option – for Europe, the U.S. and potentially others – investors need to rethink their overall approach and brace for more extreme economic and market events.
Second, there is no free lunch. There never really was, but investors are facing even more difficult trade-offs today. If the objective is to enhance yield or upside potential through credit, high yield, emerging markets, equities or other risk sectors, the likely trade-offs in a bi-modal world are higher volatility and greater downside. If the goal instead is to own ‘safe haven’ assets for downside risk mitigation, such as U.S. Treasuries, U.K. gilts or German bunds, the trade-off is currently negative real yields. And if the need is to maximise liquidity through cash instruments, the payoff is truly negative real yields (with negative nominal yields on occasion). Even when seeking inflation protection, whether through inflation-linked bonds or hard assets – like gold, real estate and commodities – we believe the trade-offs in terms of real yields, volatility and downside risk are much less attractive in this environment.
Third, investors need to think differently with respect to allocations, benchmarks and guidelines. We’ve highlighted this in the past, but it’s even more important today. In our view, asset allocation should be risk-factor-based as bi-modal distributions and accelerants are not friendly toward traditional mean-variance methodologies, which aim to maximize returns for given levels of risk. Benchmarks should be GDP- rather than market value-weighted, particularly in fixed income space, to reduce exposure to those countries, sectors and issuers with the highest or fastest growing debt. And guidelines should be flexible, with more rather than less discretion, so as to allow managers to play both offence and defence in a bi-modal world.
Fourth, investors should be confident in their managers’ ability to understand and measure risk. Global challenges, market accelerants and unusual uncertainty put a premium on risk management. This includes understanding how the credit sensitivity of fixed income investments can affect their duration – i.e., ‘hard’ versus ‘soft’ duration – and help determine what is considered a ‘safe haven’ and what isn’t. It means performing credit analysis of sovereigns knowing they have more than just interest rate risk. It necessitates analysing the entire spectrum of the capital structure to pinpoint exact needs in terms of collateral, covenants and other forms of defence. Derivatives continue to be useful tools, but being able to identify and control counterparty risk is increasingly important. And leverage, while appropriate in certain circumstances, needs to be well understood. Bottom line: we believe in developing multiple risk measures and stress testing often.
Finally, investors need to develop specific objectives and invest for outcomes rather than simply for beta and diversification. Many investors traditionally started with risk/return targets and used historical mean-variance analysis as a framework to determine asset allocations across multiple asset classes, with benchmarks for each asset class and sub-category, and then found managers that aimed to provide returns above their benchmarks. In the days of normal-shaped distributions and reversion to the mean, this was a widely accepted strategy: Long-term realised returns and volatility came in largely as expected, and further diversification – across asset classes, within asset classes and across different managers and styles – helped to smooth short-term swings. It was a beta-driven strategy, aided by diversification. But the world has changed, and we believe investors need to deepen their understanding of their objectives and invest for outcomes.
Setting objectives and investing for outcomes
Every investor has a unique set of needs and circumstances that should form the basis for setting investment objectives. Yet it’s important to consider the secular context as well, particularly given the challenges and trade-offs we’re likely to face:
- Prolonged period of low real yields on high-quality assets, with negative real yields on traditional ‘safe havens’
- Increased potential for low and even negative real returns
- Continued high volatility with increased likelihood of bi-modal outcomes
- Eventual, though uneven, inflation pressures
Income-oriented investors should consider emphasizing high-quality fixed income spread sectors, such as covered bonds, mortgage- and asset-backed securities, investment grade credit and, depending on risk tolerance, upper-tier emerging market and high yield issues and higher dividend-paying equities.
Investors with specific return objectives should consider focusing more on absolute return strategies, ranging from unlevered LIBOR-plus approaches – essentially seeking to outperform cash – to alternative strategies, depending on their risk/return targets and liquidity needs. Credit, emerging markets, equities and other asset classes can also play roles, individually or grouped into a multi-asset approach, as long as risk factors and exposures are well understood and investors consider ways to potentially limit downside risk under more extreme ‘left tail’ scenarios.
Investors concerned with volatility and ‘fat tail’ events should consider risk-mitigating strategies. If investors want to defend against downside, potential strategies would include positions in hard-duration, ‘safe-haven’ assets, explicit tail-risk hedges or a combination. Investors focused on liabilities may want a liability-matching or LDI program. Alternatively, if the goal is to maximise liquidity, cash and short-term strategies would likely play a significant role.
Lastly, for investors worried about reflation, the suggested focus is on potential inflation hedges, such as inflation-linked bonds, commodities and real estate.
In truth, many investors will likely want to employ more than one approach – income with an inflation-hedging component, absolute return with tail-risk hedges, LDI programs that include a combination of derivative-based overlays with LIBOR-plus strategies on the underlying collateral, or any of these with a cash buffer that can be used for liquidity or to invest tactically if the opportunity arises. And this makes sense. In our view, as long as investors focus on their objectives and their targeted outcomes, rather than fall into the old ‘invest for beta and diversification’ trap, they can navigate a world of secular challenges, accelerants and unusual uncertainty.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Covered bonds are generally affected by changing interest rates and credit spread; there is no guarantee that covered bonds will be free from counterparty default. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. Absolute return portfolios may not necessarily fully participate in strong (positive) market rallies. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Certain U.S. Government securities are backed by the full faith of the government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Dividends are not guaranteed and are subject to change and/or elimination. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
LIBOR (London Interbank Offered Rate) is the rate banks charge each other for short-term Eurodollar loans. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
Tags: Benchmarks, Central Banks, Confusions, Cornerstone, Diversification, Financial Markets, First Forum, Global Economy, Inflection Points, Investment Implications, Investment Professionals, Investment Strategy, Mohamed, Newport Beach, Normal Distributions, Occurrences, PIMCO, Political Confusion, Private Sector, Term Investment
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Tuesday, July 10th, 2012
From Mark Grant, author of Out of the Box
All You Had To Do Was Wait
“What makes people so impatient is what I can’t figure; all the guy had to do was wait.”
It was approximately twelve months ago that I called for a U.S. ten year at 1.25%. The yield back then was around 2.25%. We are a scant 26 bps from my prediction now and we have seen a 75 bps drop in yield during this time period. This has been fueled by the continuing “moments” generated in Europe and the demand for anything having some sort of safe haven status. We now have a second driver which is the recession in Europe and the substantial slowdown in the economy of China which I predict will place America in recession by either the fourth quarter of this year or the first quarter of the next.
The American stock market, always myopic in its view, is about to be hit by what it does pay attention to which is earnings. Europe represents 25% of the global economy and the recession there is about to have a very substantial impact on the revenues and profits of many American corporations. It was inevitable, as hindsight will expose, and now as our earnings season gets underway it will get documented in the numbers. If you don’t delight in losing money you will find that the yields of many senior and subordinated corporate bonds far outpace the returns of dividends and certainly the depreciation in value will be far less. Further, in times of economic stress, it is far safer as has been proved time and time again to be towards the top of the capital structure in bonds rather than in the bottom of the capital structure which is equities.
I can report a wide array and a great diversification of viewpoints on just what will take place in Europe but what also can be said with certainty is that most institutional investors all agree that there is a lot of risk on the table now. As part of this process I also wish to congratulate the media. Many commentators in the Press or on television are no longer willing to take the official press releases as fact. There are more people who are not only questioning the headlines but who are looking past them in trying to decipher not only their accuracy but there meaning. I suppose this has occurred by one announcement after another coming from the Continent that was so shaded and so misleading that eventually people woke up to the fact that inaccurate data was being provided and being provided in a systemic fashion. Then there is the timeline issue where plans are tossed out, do not materialize and are being held to account as mollifying statements that somehow never seem to achieve their goals. Whether it was the statements of the IMF and the EU that the new structural plan for Greece would produce a debt to GDP ratio of 120% or the giant firewall that would prevent Spain or Italy from ever needing to be bailed out or the bailout for Spain which their Prime Minister called “A Great Victory for Europe;” the cries of “wolf” are falling on less and less accepting ears.
“The secret of being a top-notch con man is being able to know what the mark wants, and how to make him think he’s getting it.”
It may work, for a moment, to rally equities after the next new piece of sliced white bread is announced but then the reaction flattens out and then the market declines as reality sneaks back in and finds its rightful place at the table. From the very beginning with the first European bank stress test which counted what Europe wanted to be counted and ignored what should have been counted to the second one which was falsified by its methodology; results begin to occur and calamities begin to happen, such as with Dexia, as the real data forced what the phony data reported tried to hide. Europe may cook the books and allow for risk-free assets or the Spanish central bank may allow for “smoothing” and carrying Real Estate at levels with no reflection of reality in them but when mortgages are not paid and commercial loans are delinquent; the lack of revenues and profits tell the accurate tale whatever was allowed to be ignored or not.
All of the time wasted on firewalls and great deceptions worked in the short term but the height of a fence does nothing to help a horse or a nation which is sick inside them. Europe has vastly overspent and tried their best to whitewash the financials of the countries and the European banks and now, and each quarter out for some time; we are going to see a worsening financial landscape for the European nations and their banks. This will not be Armageddon or the end of the world but it is going to be quite painful and have a decided impact on the United States and perhaps the scaring may be deep. In Europe that have mouthed so much nonsense for such a long period of time that they have come to believe in what they have manufactured. This is not uncommon historically but the depth and breadth of it is without comparison. Germany says one thing to placate France and Italy believes the drivel that is touted by the Netherlands and now Greece wants the ECB to forgive their $238 billion in Greek debts on the basis of a united Europe, which would bankrupt the ECB, and then it becomes clear that someone has to pay for all of this and countries start banging on the doors of the asylum to get out. Listen carefully; the banging has begun and will grow loader and more raucous during the balance of the year.
“The world news might not be therapeutic.”
-One Flew Over The Cuckoo’s Nest
Tags: American Corporations, American Stock Market, Bps, Capital Structure, Commentators, Corporate Bonds, Depreciation, Diversification, Earnings Season, Economic Stress, Economy Of China, Global Economy, Having Some Sort, Hindsight, Institutional Investors, Mark Grant, Recession, Safe Haven, Slowdown, Substantial Impact
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Wednesday, June 13th, 2012
The following is a letter from Russ to his son.
You’re seven, a great age for many reasons. You’re old enough that I no longer have to watch Thomas the Train. You’re still young enough that when we read together, you let me pick at least a few books that I like (one day I’ll need to apologize for making you sit through several hundred renditions of Yertle the Turtle), and you still get excited when I bring you back a stuffed kangaroo from Australia. In short, you’re at an age when I can still solve most of your problems.
I know that won’t last. Eventually you’re going to need to go out and find your place in the world. So this Father’s Day, I thought I should take the opportunity to offer some advice, or at least advice relating to your financial well- being.
My number one recommendation is to find a job you truly love doing because you’re going to be doing it for a very long time. This was always good advice, but it’s likely to be even more pertinent for your generation. Recently my generation and the previous one have gotten into somewhat of an odd habit: we live much longer but want to retire much younger. This probably has to change. If you can find something you think you can do for, say, fifty years or so that would be a good thing.
Also, when you finally do decide to retire, the government may not be of much help. That will be all right, assuming you follow my second admonition: save. This is both the easiest and hardest one to follow. It’s easy because unlike picking a career or picking a stock, both of which involve a lot of uncertainty, saving requires no special foresight. It does, however, require discipline, and the earlier you start the better.
The third bit of advice concerns what to do with those savings. This is a big topic but, for now, concentrate on just two things: value and diversification. Always remember the price you pay matters, even when investing. This is something many in my generation forgot during the tech bubble when we told ourselves that Internet companies with no revenue should be worth several billion dollars. Second, no matter how good an investment looks, don’t own too much of it. There are very few free lunches in finance, or in life. If you want more return, you need to take more risk. Diversification is the one loophole to this rule.
That’s pretty much it. Find a job you love, save early and often, be a value investor and don’t put all your eggs in one basket. Nothing that original, but I’d like to believe that following this advice will save you from at least a few of life’s little hiccups. And know that if you stumble, I’ll always be there, stuffed kangaroo in hand.
Tags: Admonition, Australia, Books, Dear Son, Discipline, Diversification, Fifty Years, Financial Advice, Find A Job, Foresight, Good Advice, Habit, Kangaroo, Long Time, Picking A Career, Renditions, Russ, Thomas The Train, Turtle, Uncertainty
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Tuesday, May 22nd, 2012
With both gold and broader commodity indices down significantly month to date, many investors are asking if they should lower or even remove their commodity exposure. I believe the answer is no.
First, it’s useful to put the recent weakness in perspective. Both gold and a broad basket of commodities are down roughly 10% over the past three months. While the losses represent a significant correction, they are in line with the performance of equity markets over the same time period. Even more importantly, here are three reasons for maintaining a strategic exposure to commodities.
1.) Diversification: Commodities typically behave differently from paper assets like stocks and bonds even as correlations between all risky assets have risen in recent years. In fact, based on historic relationships, it doesn’t take a large allocation to commodities – it typically takes less than 10% – to improve the risk-adjusted returns of a strategic portfolio.
2.) Inflation: Commodities tend to perform best when inflation is rising. As I mentioned last week, while I see little risk of double-digit inflation in the near-term, inflation is not completely dead. Core inflation in the United States is rising at 2.3% year over year, a 3 ½-year high. Given the US fiscal position and the unconventional nature of recent monetary policy, there is a non-trivial risk that we may see more than 2.3% inflation over the next decade. Over the long term, even modest inflation would erode purchasing power. Commodities can offer an effective hedge against this scenario.
3.) Potential tailwind from monetary policy: While commodities have suffered recently, the performance hasn’t been awful. The S&P Goldman Commodities Index is down roughly 5% year to date. Meanwhile, gold was up around 2% through the end of last week, returns that still compare favorably with most equity markets outside of the United States.
One reason for the resilience, as I’ve written before, is that commodities and gold generally benefit when real interest rates are negative. In such a rate environment, there’s no opportunity cost for holding commodities, and commodity returns tend to be higher. At least historically, the level of real interest rates has been far more important to commodity returns than either inflation or the dollar. In fact, over the past twenty years, the variation in real interest rates explains roughly 60% of the variation in the annual return of gold. To the extent the Fed, and most other major central banks, are determined to keep real rates negative for the foreseeable future, we’ll be in an environment supportive of commodities, particularly gold.
To be sure, commodity prices are likely to remain volatile – along with just about every other risky asset – in the near term as investors worry about the potential for a disorderly default by Greece impacting the global economy. However, for investors, especially those currently underweight commodities, now may very well be a good long-term buying opportunity (potential iShares solution: NYSEARCA: IAU).
Past performance does not guarantee future results. Diversification and asset allocation may not protect against market risk.
iShares Gold Trust (“Trust”) has filed a registration statement (including a prospectus) with the SEC for the offering to which this communication relates. Before you invest, you should read the prospectus and other documents the Trust has filed with the SEC for more complete information about the issuer and this offering. You may get these documents for free by visiting www.iShares.com or EDGAR on the SEC website at www.sec.gov. Alternatively, the Trust will arrange to send you the prospectus if you request it by calling toll-free 1-800-474-2737.
Investing involves risk, including possible loss of principal. The iShares Gold Trust (“Trust”) is not an investment company registered under the Investment Company Act of 1940 or a commodity pool for purposes of the Commodity Exchange Act. Shares of the Trust are not subject to the same regulatory requirements as mutual funds. Because shares of the Trust are intended to reflect the price of the gold held by the Trust, the market price of the shares is subject to fluctuations similar to those affecting gold prices. Additionally, shares of the Trust are bought and sold at market price not at net asset value (“NAV”). Brokerage commissions will reduce returns.
Shares of the Trust are intended to reflect, at any given time, the market price of gold owned by the Trust at that time less the Trust’s expenses and liabilities. The price received upon the sale of the shares, which trade at market price, may be more or less than the value of the gold represented by them. If an investor sells the shares at a time when no active market for them exists, such lack of an active market will most likely adversely affect the price received for the shares. For a more complete discussion of the risk factors relative to the Trust, carefully read the prospectus.
Following an investment in shares of the Trust, several factors may have the effect of causing a decline in the prices of gold and a corresponding decline in the price of the shares. Among them: (i) Large sales by the official sector. A significant portion of the aggregate world gold holdings is owned by governments, central banks and related institutions. If one or more of these institutions decides to sell in amounts large enough to cause a decline in world gold prices, the price of the shares will be adversely affected. (ii) A significant increase in gold hedging activity by gold producers. Should there be an increase in the level of hedge activity of gold producing companies, it could cause a decline in world gold prices, adversely affecting the price of the shares. (iii) A significant change in the attitude of speculators and investors towards gold. Should the speculative community take a negative view towards gold, it could cause a decline in world gold prices, negatively impacting the price of the shares.
Shares of the iShares Gold Trust are not deposits or other obligations of or guaranteed by BlackRock, Inc., and its affiliates, and are not insured by the Federal deposit Insurance Corporation or any other governmental agency.
BlackRock Asset Management International Inc. (“BAMII”) is the sponsor of the Trust. BlackRock Investments, LLC (“BRIL”), assists in the promotion of the Trust. BAMII and BRIL are affiliates of BlackRock, Inc.
Tags: Amp, Commodities, Commodity Indices, Core Inflation, Correlations, Diversification, Fiscal Position, Goldman, Monetary Policy, Nbsp, Paper Assets, Purchasing Power, Resilience, Risk Adjusted Returns, Risky Assets, Same Time Period, Stocks And Bonds, Tailwind, Term Inflation, Three Months
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Monday, May 14th, 2012
Panic Is Not a Strategy—Nor Is Greed
- Originally publishing in 2008, it’s time for a refresher about the perils of panic.
- Asset allocation, diversification and rebalancing are as close to a “free lunch” as you can get as an investor.
- In a world where time horizons have shrunk precipitously, think longer-term.
If markets are good at one thing, it’s reminding investors that they don’t go up uninterrupted forever. We witnessed several bruising corrections in 2011 before the market’s strong rally between October 2011 and April 2012. As the chart “Fear Spikes Again” below illustrates, the CBOE Volatility Index® has picked up again, but remains below the unparalleled heights of the 2008 credit crisis and the more-recent elevation in 2011.
Fear Up, But Well Down From Highs
Source: FactSet, as of April 20, 2012. The CBOE Volatility Index (“VIX”) is a registered trademark of the Chicago Board Options Exchange. The VIX Index shows the market’s expectation of 30-day volatility. For more information on the VIX, visit www.cboe.com/micro/vix/
We’re always quick to remind investors that neither panic nor greed is an investment strategy, and that the best foundation to help protect a portfolio against the unpredictable is having—and sticking with—a long-term strategic asset allocation plan.
Mindset matters: strategic trumps tactical
In reality, investors should rarely, if ever, react to a dramatic short-term move in the market. As intriguing as it may seem to try to catch bottoms and get out at tops in order to reap big profits (or so you think), the “tactical” (or shorter-term) approach to investing has its limitations … and its risks.
We believe it’s the “strategic” asset allocation decision—and the ability to stick with it through the discipline of rebalancing—that will ultimately reap the greatest rewards. These decisions are not a function of short-term market gyrations or forecasts (mine, yours or anyone else’s), but are tied to your risk tolerance and long-term goals. Developing and maintaining the right long-term asset mix is by far the most important set of decisions a client will ever make.
Never before has information about the global economy and markets been more readily available and disseminated. As a result, global markets have become very interconnected. In turn, our reaction mechanisms have kicked in, and investor time horizons have shortened dramatically—but not necessarily to our advantage. Yes, the long term is really just a series of short-term events, but it’s how we react to them that decides our ultimate fate as investors.
Asset allocation and diversification: investors’ “free lunch”
One of the most important areas where Schwab offers advice is the development of a long-term strategic asset allocation plan. Many investors assume that their position along the risk spectrum from conservative to aggressive is largely based on their age and time horizon. But a more important factor is their risk tolerance. Also important is judging the difference between an investor’s financial risk tolerance (their ability to financially withstand volatile markets) and their emotional risk tolerance—a spread that’s often quite wide and only acknowledged during tumultuous market environments.
I’ve known plenty of older investors who thrive on the risk associated with an aggressive investment stance. I’ve also known plenty of young investors who can’t stomach any losses. Too often, investors use a rearview mirror to make their investing decisions, by looking at past performance as a guide to future results. A mirror is a valuable tool but only when turned on yourself to judge your own circumstances—tolerance for risk, time horizon, income needs, etc. As I’ve often said, there are very few free lunches in investing. Asset allocation, diversification and periodic rebalancing are as close as you get.
Risk tolerance: Know what you can stomach
In the chart “Schwab’s Strategic Asset Allocation Models” below, you’ll see our long-term recommendations regarding different asset classes for three types of investors: conservative, moderate and aggressive.1 Note the vast differences in allocations to riskier asset classes, including international equity, as you move up the risk spectrum.
Clearly, over the long term, given the better performance by the riskier asset classes, a more aggressive allocation has historically reaped higher rewards in terms of returns. But there is a dark side to an aggressive posture’s higher returns—the risk taken in getting there.
Tags: Allocation Plan, Cboe Volatility Index, Charles Schwab, Chicago Board Options, Chicago Board Options Exchange, Chief Investment Strategist, Credit Crisis, Diversification, Free Lunch, Greed, Investment Strategy, Liz Ann, Perils, Rewa, Senior Vice President, Strategic Asset Allocation, Term Approach, Time Horizons, Unparalleled Heights, Vix Index, Volatility Index Vix
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Sunday, April 22nd, 2012
by Chuck Carnevale, FAST Graphs
There’s an old cliché about real estate investing that states that the three cardinal rules are: location- location- location. Clever pundits have borrowed upon this refrain and glibly state that the three most important or cardinal rules of investing are: diversify- diversify- diversify. However, careful analysis will reveal that diversification is a multifaceted concept that has different meanings, benefits and even risks depending on how it’s used and what its ultimate purpose is. Therefore, my goal is to examine this ubiquitous investing concept from various angles and perspectives.
Diversification Within or Across
When thinking about diversification there are at least two broad categories to contemplate. The first I would call broad diversification or spreading the risk across numerous asset classes. To me, this is analogous to the throw as much mud on the wall as you can while hoping that some will stick idea. Many experts advocate the diversifying broadly approach. However, to my way of thinking, the idea of diversifying just for diversification sake is not always a sound idea. In other words, I would never advocate putting money into an investment that prudent analysis indicated was a bad place to invest just for the sake of so-called diversification.
For example, and I know it is going to generate strong disagreement, I think gold is an asset class at a bubble valuation that should be currently avoided. Personally, I sold mine last summer. The following graph courtesy of Goldprice.org says it all. Gold was an attractive investment in the late 1990’s to early 2000’s, but it is clearly at extremely high levels now. Therefore, I would suggest taking some (or even all) profits. As I have written before, I feel that fixed income (bonds, etc.) is also at an extreme, and therefore, I temporarily also favor avoiding this asset class. I feel that asset classes should only be used for diversification when they are prudent and sound. To force money into a dangerous investment solely for an artificial commitment to diversification makes no sense to me.
Gold a Twenty year History (Courtesy of Goldprice.org)
Furthermore, I tend to have a much narrower view of asset classes than many of my peers. Regarding liquid assets I see only what I call owner-ship or loaner-ship. Where owner-ship represents equity with the investor positioning themselves as an owner/shareholder, and loaner-ship where the investor loans their money at interest. Others might call this equity versus fixed income or stocks versus bonds. In addition to these liquid assets there would also be hard assets such as real estate, precious metals, commodities and art forms that could be considered as options. But the most important point is that deciding what the most appropriate or optimum percentage of your assets should be allocated to these various asset classes is a subject of much debate.
Diversification-what is the goal?
The most common definition, and therefore use, of diversification is as a risk management technique. This most basic concept of diversification says that you should not put all of your eggs in one basket. On the other hand, assuming that this is wise counsel raises the question: how many baskets is the appropriate number? Should you spread your money over 5 baskets, 10 baskets, 20 baskets, 100 baskets or 1000 baskets? In other words, what is the optimum number of baskets; how many baskets are enough and/or how many are too many?
When dealing with broad diversification, I refer you back to my previous comments regarding equity versus debt. There are many who advocate cute little rules that they promote as the proper way to apply broad diversification. For example, one of the more popular rules of thumb goes something like this: Subtract your age from 100 and put the resulting percentage in stocks; the rest in bonds. In other words, if you’re 20 years old, put 80% of your assets in stocks; 20% in bonds. If you are 60 years old, put 40% of your assets in stocks and 60% in bonds, etc. Somehow, these little rules of thumb leave me cold. To my way of thinking, a proper asset allocation plan should be based on the individual’s goals, objectives and risk tolerances. When dealing with these kinds of issues, one size rarely fits all.
Next there’s the issue of whether your diversification objectives are geared towards reducing risk or maximizing return. An investor with a high tolerance for risk would take a different view of what optimum diversification is versus a person who is very risk averse. An individual with a high tolerance for risk might choose only to invest in equities in lieu of owning any fixed income assets. Who can say that this is a bad decision when it suits the investors’ goals and risk tolerances? This then takes us to the questions pertaining to optimum diversification within an asset class.
The most interesting aspect of these important questions is the fact that there is no consensus view. Some experts argue in favor of more diversification while others favor less. For example, Charlie Munger, the famed partner of Warren Buffett, believes that 3 to 5 companies in a stock portfolio is enough diversification. Charlie is alleged to have said that diversification is for idiots. And he is quoted as saying: “wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results. “ Alternatively, Warren Buffett seems to agree and has said: “diversification is protection against ignorance.”
In contrast, Peter Lynch, the famed manager of the Fidelity Magellan Fund during its glory years held more than 1000 stocks in his portfolio. What is most amazing about this fact is that Peter created one of the strongest long-term track records of any mutual fund that ever existed. Ironically, this is the same man who is credited with coining the phrase “di-worse-i-fication.” What many people fail to realize about this is that Peter was referring to an individual company diversifying outside of its core competency through acquisitions. Yet when building his own portfolio, he was happy to own hundreds or even thousands of individual companies.
Then of course there is another aspect of diversifying within an asset class. As it pertains to equities, investors could have a choice of various classes of common stocks. These would include growth stocks versus dividend paying stocks, small stocks versus large stocks, etc. Once again, the investor is faced with the issue of how much should be in growth, how much should be in value, how much should be in large, how much of the small, and on and on. I don’t believe there is a general answer. The right answer is the answer that best fits the individual’s needs and goals.
And the same concept would apply to investing in bonds. A prudent bond investor might want to ladder their portfolio over various maturities. How much they would allocate to longer maturities versus how much they would allocate to shorter maturities would depend on their belief as to where interest rates might be headed in conjunction with where they feel they are today. If the investor feels that rates are very low they would want to rely more on shorter maturities so that their money would mature into higher interest rates, if they believe rates were going higher. Conversely, if they feel that interest rates are very high they would want to orient their portfolio to the longest maturities possible in order to lock in the higher rates for as long as they possibly could. These considerations would have a major impact on their overall diversification strategy.
There is another argument that the Buffets and Mungers of the world offer against broad diversification. These investors who favor a more concentrated approach believe in essentially two things. First, they believe that extraordinary above-average investments are rare. They further argue that every investment you add would be, or should be, of lesser opportunity than your best choice is. In other words, your best stock will generate a higher return than your second best and so on. Their second belief is that you can only truly know enough about a very select number of companies to be able to invest wisely. Therefore, the more companies you include in your portfolio, the more diluted your knowledge about each will be. In other words they believe in placing all their eggs in one basket (or at least a very few baskets) and then watch that basket very carefully.
Diversification For Maximum Return Or Minimum Risk
As I’ve previously alluded, diversification is most commonly thought of as a way to reduce risk. However, the opposite side of the diversification coin is rate of return. Diversification, or the lack thereof, will have or should have a large and direct impact on the ultimate return that a portfolio will generate. However, the precise impact is once again a matter of debate. For example, in theory, the more fixed income a portfolio contains the lower the rate of return it would be expected to generate. In his best-selling book Beating the Street, Peter Lynch offered up this 26th Rule of his 25 Golden Rules of Investing (yes, it was his 26th of 25):
“in the long run, a portfolio of well-chosen stocks and/or equity mutual funds will always outperform a portfolio of bonds or a money market account. In the long run, a portfolio of poorly chosen stocks won’t outperform the money left under the mattress.”
Or you might prefer Peter’s principle number two:
“gentlemen who prefer bonds don’t know what they are missing.”
Perhaps the moral of this story is that diversification has its pluses, but also has its minuses. While it can protect against risk and even smooth out long-term returns; it accomplishes all this at a cost. The seminal question is whether or not you, the individual investor, is willing or even capable of paying the price? Or put another way, how much rate of return are you willing to give up, to buy how much peace of mind? Again, I see this as an individual decision, and perhaps even more importantly, a function of the amount of knowledge you the individual investor possesses and the amount of volatility risk you can endure. Clearly, most of us are not Charlie Munger or Warren Buffett that can afford the luxury of a highly concentrated portfolio. On the other hand, we don’t want to be guilty of “di-worse-ification” either. At the end of the day, finding the right balance is as much a personal thing as it is an ironclad principle. At least it is in my way of thinking.
A Fun Look at Diversification Within the Asset Class Equity (stocks)
As I went through the process of researching diversification I came across some interesting results that frankly astounded me. Therefore, I thought it would be fun to share what I discovered. First of all, the primary goal of my research was an attempt to ascertain how much diversification within an asset class was the appropriate amount. Stated more simply, how many stocks were enough to protect the money and how many stocks were too much to dilute or destroy returns. Although I didn’t come up with a precise answer that satisfied me, I did discover some fascinating numbers.
Utilizing the F.A.S.T. Graphs research tool I ran 20-year track records on several well-known indices that contained a low of 30 stocks all the way up to 5000 stocks. Before I ran these various records, I assumed that the indicie with the least number of companies would produce the highest rates of return and vice versa.
30 Dow Jones Industrials’ 20-year Record
My first example is the DJIA, because it is a diversified portfolio but only contains 30 names. As expected, the 30 Dow Jones Industrials did produce the highest rate of return at 7.3% per annum.
The S&P 500 Without Dividends
My second example is the S&P 500. Since the index contains 500 companies, I expected to see a lower annual rate of return due to the much broader diversification. Even though I was correct, the return differential was only 1.2% per annum coming in at 6.1%. From the standpoint of risk, you could say that you didn’t give up much return for the greater safety.
Since this article is all about diversification, I have included the sector breakdown of the S&P 500 in order to illustrate the diversification within this broad index. I found it interesting that Information Technology was the biggest sector at 20.46%. To me this indicates that the S&P 500 is actually an aggressive index, even though it is diversified.
Russell 3000 Index Without Dividends
With my third example I increased the size of the universe by a factor of 5 by calculating the Russell 3000. Astonishingly, this larger universe actually generated a modestly higher rate of return of 6.3% per annum versus 6.1% for the S&P 500. In this case, greater diversification actually increased my return, but not by very much.
The Dow Jones Wilshire 5000
With my final example I calculated the Dow Jones Wilshire 5000 composite which at 5000 names was the biggest index I could find. Remarkably, this biggest index of all produced the second highest rate of return at 6.4% per annum.
Frankly, I’m not really certain what to make of the results I discovered. From what I learned, diversification doesn’t really impact the rate of return by very much when looked at from the perspective of the average company in the universe. This led me to wondering what a universe of the top 10 best performing stocks might look like. Of course I recognize that the flaw in this line of thinking would be having the foresight to pick the top 10 at the beginning of this exercise. However, my curiosity was not about being smart enough to pick the very best; instead, I was just curious to know what the differentials would actually be.
Therefore, I first sorted the top 10 of the 30 Dow Jones Industrials and listed them in order of best-performing to lowest-performing for the past 20 years. The average performance of an equally weighted investment in each of these candidates would have averaged approximately 13.8% per annum which is just shy of doubling the rate of return for the entire composite of 30 names. To put this into perspective, $1 million equally allocated total investment spread into these top 10 companies would grow to over $12 million in 20 years. I thought this was interesting, but not terribly exciting. The following table shows the results of the top 10 best-performing 30 Dow Jones Industrials with $100,000 invested in each at the beginning of 1993.
With my second example I went to the larger universe of the S&P 500. With a much bigger universe to draw upon a discovered a significantly higher average rate of return. As it relates to diversification, I’m really not sure what this means other than a bigger universe offered a much bigger opportunity to find significantly above-average investments. The top 10 best-performing S&P 500 companies produced an average return of almost 25% per annum. Therefore, the same $1 million equally allocated across these 10 names grew to over $68 million. Now, that number got my attention.
Now, once again, admitting that this last little exercise is fraught with error, I do feel that it revealed some interesting information. Perhaps most importantly, it did reveal a large disparity between the best performers versus the average performance. If you did possess the skills of a legendary investor, you just might be better served to focus your attention on only a few of the very best companies you could identify. However, for the rest of us we might be best served by placing our money spread out and into more baskets.
Summary and Conclusions
As I began digging into the many faces of diversification, I quickly learned that it is a much more complex concept than at first meets the eye. But perhaps most importantly of all, I feel I learned that there is no one-size-fits-all or even a set of universally applicable rules or principles. To a great extent, diversification turns out to be a very personal issue. How much or how little depends more on your goals and objectives, the knowledge and experience you possess, the time you can allocate to your investment portfolio, and of course, your tolerance for risk. Some of us need a great deal of diversification, while others could do with a lot less.
I will conclude this article by confidently stating that it only scratches the surface of what a comprehensive treatise on diversification would require. In many ways, I feel that I raised more questions than I answered. Therefore, I expect that more articles will be forthcoming. The one area that I feel I shortchanged the most was the area of broad diversification across many different asset classes. Consequently, an article dealing specifically with this aspect of diversification seems like a logical next step. However, I will end by saying once again that I believe that it is also a very personal concept. On the other hand, I do believe that no asset class should ever be used unless it makes prudent economic sense to include it.
Disclosure: Long MCHP, MSFT, CVX, ESRX, XOM, UTX, CSCO & INTC at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Tags: Angles, asset class, Asset Classes, Attractive Investment, Cardinal Rules, Careful Analysis, Disagreement, Diversification, Fixed Income, Graph, Graphs, Income Bonds, Location Location Location, Mud, Multifaceted Concept, Nbsp, Pundits, Refrain, Sake, Sound Idea
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Wednesday, April 18th, 2012
by Russ Koesterich, iShares
After a disappointing, frustrating and, at times, terrifying 2011, patient investors were rewarded with a stellar start to 2012. In the first quarter, equity markets banked a performance that would have been respectable for the full year. Developed markets gained nearly 11%, while emerging markets advanced more than 13%. However, equity markets have lost some steam in recent days, and now many investors are wondering if there’s anything to look forward to in the second quarter.
The good news is that even after the rally, valuations still appear reasonable. Developed markets are currently trading at around 14x earnings, no longer a screaming bargain but below historic averages. Emerging markets, meanwhile, are even cheaper, trading at less than 12x trailing earnings. In addition, inflationary pressures remain well contained and while last Friday’s disappointing employment report reminded everyone that the recovery will continue to be slow and uneven, both the US and global economies are stabilizing.
That said, I don’t expect markets in the second quarter to be all smooth sailing. While markets can still move higher, gains are likely to be predicated on earnings growth, which in turn will depend on further improvement in the global economy. And even if the economy continues to stabilize, we’re unlikely to see another round of quantitative easing until at least July as the Fed’s Operation Twist is set to continue through June.
Without the sedative of easier monetary policy, markets are likely to be more volatile. I expect volatility to be in the high teens to low 20s, above the mid-teen levels that characterized the first quarter. In fact, it’s probably fair to say that the first quarter rally was more a function of continuing, and arguably intensifying, central bank generosity rather than a reflection of fundamentals experiencing a complete turnaround.
Given this environment, as the second quarter kicks off, investors should consider repositioning their portfolios to access international equity income, prepare for more volatility and shift into investment grade credit.
As I’ve mentioned before, in an environment of slow growth and more volatility, higher income stocks are more likely to outperform. However, such stocks currently look expensive in the United States, meaning investors may want to cast a wider net to get their dividend exposure through vehicles such as the iShares Dow Jones International Select Dividend Index Fund (NYSEARCA: IDV) and the iShares Emerging Markets Dividend Index Fund (NYSEARCA: DVYE).
In addition, as the market becomes more volatile, investors may want to consider equity funds that employ a minimum volatility methodology that can potentially help insulate portfolios from wild market swings. Such funds typically hold lower-beta stocks than similar, cap-weighted benchmarks and have historically produced higher risk-adjusted returns over the long-term.
Finally, as I wrote earlier this month, while high yield can still offer a good coupon, investment grade debt, accessible through the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA: LQD), looks cheaper and should hold up better during a more volatile quarter.
The author is long LQD and IDV
International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. There is no guarantee that dividends will be paid.
Minimum volatility funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.
Bonds and bond funds will decrease in value as interest rates rise.
Past performance does not guarantee future results.
Tags: Asset Allocation, Columbia Management, Credit Crisis, Diversification, Earnings Growth, Emerging Markets, Employment Report, Financial Situation, First Quarter, Generosity, Global Economies, Global Economy, Inflationary Pressures, Investment Advisers, Investment Mix, Iranian Hostage Crisis, Ishares, Last Friday, Market Crash Of 1987, Market Fluctuations, Monetary Policy, Ned Davis Research, Patient Investors, Portfolio Holdings, Q2, Quarter Rally, Rebalancing, Reflection, Risk And Reward, Risk Tolerance, Russ, Second Quarter, Sedative, Smooth Sailing, Stock Market Crash, Stock Market Crash Of 1987, Substantial Market, Time Horizon, Turnaround, Valuations, Volatility, Weather Market
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Tuesday, April 10th, 2012
by Michael Nairne, Tacita Capital
“Buy and hold” is not an effective strategy for risk conscious investors. Any portfolio’s asset mix will drift from its strategic target as asset prices move differentially in response to changing economic and market forces. Over time, the higher return assets will comprise a larger proportion of the portfolio and distort its return and risk dimensions from those originally constructed.
Sound portfolio management is founded on “buy and rebalance”. Rebalancing involves selling the asset classes that have done relatively well to buy those assets that have lagged in order to restore the portfolio’s target mix. Rebalancing is vital in risk management since it ensures that a portfolio’s risk dimensions stay within an investor’s defined tolerance limits. This is illustrated in the following graph which compares the return and risk of a portfolio comprised of 40% US bonds and 60% US stocks which was rebalanced annually (in red) to those of the same portfolio that was never rebalanced (in orange).
The rebalanced portfolio experienced much lower risk while the never rebalanced portfolio drifted into a much riskier asset weighting dominated by stocks. Its return was lower but that is because it avoided the escalating risk of the never rebalanced portfolio. Critically, the rebalanced portfolio had better risk-adjusted performance .
Rebalancing has a second vital role in a portfolio. Rebalancing is a source of diversification return that arises from the contrarian act of selling assets that have appreciated on a relative basis and buying the lagging assets in order to restore the weights of the target asset mix of a particular investment strategy.
A return premium is created by the disciplined act of regularly “selling high and buying low” while maintaining the risk profile of the portfolio. It can be calculated by comparing the return of a rebalanced portfolio to the weighted average geometric return of the assets which comprise the portfolio . An example of the rebalancing premium is illustrated in the following table which sets out the returns of the individual assets in the 40% bond/60% stock portfolio, the weighted average return of the two assets, the return of the rebalanced portfolio and the rebalancing premium.
The rebalanced portfolio had an annualized return of 8.60% compared to the weighted average return of 8.06% for the two assets that comprise the portfolio. Rebalancing resulted in an annualized return premium of 0.54%.
The rebalancing premium can be increased by adding more assets when they exhibit the right blend of volatility and covariance (i.e. tendency to move in tandem) with the overall portfolio – the more volatile the assets added and the lower their covariance, the higher the rebalancing premium. This is illustrated in the following graph which portrays the annualized rebalancing premium for the period January 1972 to January 2012 that resulted from sequentially adding asset classes to a two asset portfolio comprised initially of 40% US bonds and 60% US stocks. The assets added in order are: international stocks, US small value stocks, Canadian stocks, US REITs, and finally gold .
The rebalancing premium more than doubled – from 0.44% to 0.99% – as assets were added. It increased initially as international stocks increased rebalancing opportunities. Then, the addition of volatile small cap value stocks had a large premium as its wide return swings created an even greater rebalancing effect. Adding real estate and commodity-biased Canadian stocks also increased the premium. Finally, adding gold which is very volatile and has a low covariance to other assets had a particularly large premium as there were frequent opportunities for substantive rebalancing.
Earning the rebalancing premium is easier in theory than in practice. Selling winners to buy losers seems to go against human nature. In fact, the vast majority of investors either don’t rebalance or don’t rebalance as frequently as they should .
That’s too bad. Rebalancing earns a return premium while maintaining the risk profile of a portfolio – to paraphrase Scott Willenbrock, rebalancing adds a “free dessert” to the “free lunch” served by diversification. Serious investors need to stay seated long enough at the investing table to enjoy both.
1. Bond and stock returns are from Ibbotson’s intermediate-term government bond and large company stock series. Rebalancing is undertaken on an annual basis.
2. Although not shown, the rebalanced portfolio had a higher Sharpe Ratio, Sortino Ratio and M-Squared Ratio.
3. Booth, D.G., Fama, E.F., Diversification Returns and Asset Contributions, Financial Analysts Journal, Vol. 48, No.3, p. 26–32, May/June 1992. Booth and Fama define the incremental return from a rebalanced portfolio compared to the weighted average asset compound return as the “diversification return”.
4. Willenbrock, Scott, Diversification Return, Portfolio Rebalancing, and the Commodity Return Puzzle, Financial Analysts Journal, Vol. 67, No. 4, pp. 42-49, July/August 2011. Willenbrock states that “the diversification return is the difference between the geometric average returns of both a rebalanced portfolio of volatile assets and a balanced portfolio of hypothetical assets with the same weights and geometric average returns as the true assets but zero volatility.” Practically, the latter term is the weighted average geometric return of the assets comprising the portfolio.
5. All return data is from Morningstar Encorr. The asset classes are based on the following indices: international stocks – MSCI EAFE; US small value stocks – Fama-French Small Value; Canadian stocks – S&P/TSX Capped Composite in US$; US REITs – FTSE NAREIT All Equity REIT; and gold – London Fix Gold PM US$. Proportions added vary but are based on practical weighting considerations. Rebalancing is undertaken on an annual basis.
6. AllianceBernstein Investment Research and Management Asset Allocation Research 2005. Findings of a nationwide telephone survey of 1000 investors.
Tacita Capital Inc. (“Tacita”) is a private, independent family office and investment counselling firm that specializes in providing integrated wealth advisory and portfolio management services to families of affluence. We understand the challenges of affluence and apply the leading research and best practices of top financial academics and industry practitioners in assisting our clients reach their goals.
Tacita research has been prepared without regard to the individual financial circumstances and objectives of persons who receive it and is not intended to replace individually tailored investment advice. The asset classes/securities/instruments/strategies discussed may not be suitable for all investors and certain investors may not be eligible to purchase or participate in some or all of them. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.
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Tags: Asset Classes, Asset Mix, Asset Prices, Assets, Buy And Hold, Diversification, Graph, Investment Strategy, Portfolio Management, Portfolio Rebalancing, Proportion, Relative Basis, Retu, Risk Management, Risk Profile, Sound Portfolio, Tacita, Target, Tolerance Limits, Weights
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Friday, March 30th, 2012
Does GOLD Still Glitter?
by James Paulsen, Chief Investment Strategist, Wells Capital Management (Wells Fargo)
Gold has been an investment darling in recent years. Indeed, it is often perceived as the cure for any investment worry. Whether you are concerned about inflation, deflation, government deficits, war, a U.S. dollar collapse, recession, or depression—GOLD is the answer!
The extraordinary popularity of gold today is easy to understand—it has done so well for so long! Since the end of the 1990s, the price of gold has risen almost six-fold from less than $300 to its current price of almost $1,700. Many expect the price of gold to rise considerably higher in the next several years and perceive the modest decline in the gold price since its all-time peak last September as a buying opportunity. While owning some gold is fine for all investors (diversification is paramount), we think gold weightings should be scaled back in most portfolios. The yellow metal may soon lose some of its luster as its struggles with its newly elevated valuation and with the likelihood that confidence throughout the economy is beginning to improve.
Gold is OVERVALUED!
Unlike stocks or bonds, gold has always been more difficult to value since it produces no cash flow (i.e., earnings or coupons) that can be discounted to arrive at a present (fair) value. However, Exhibit 1 illustrates a simple “relative valuation” methodology providing an historical perspective against most other investment classes (e.g., stocks, bonds, commodities, and real estate) and relative to the value of labor and a basket of consumer goods and services. In each of the six charts shown, the price of gold on a relative basis is either nearing or is at one of its highest valuations of the last 50 years. At the end of the 1990s, it took almost 5.5 ounces of gold to buy the S&P 500 Stock Price Index. Today, it only takes 0.8 of a single ounce to buy the stock market. Relative to stocks, gold is almost as expensive today as it was in the late 1970s when the price of gold had surged after its peg was eliminated and after the stock market was ravished by a decade of runaway inflation.
Relative to Treasury bonds, the price of gold currently trades near an all-time, post-war record high surpassing its old relative valuation record established in the late 1980s when bonds were incredibly cheap. It is indeed remarkable that gold today is this expensive relative to an asset class (bonds) which most agree is probably itself extremely overvalued.
In recent years, while gold prices have soared, U.S. home prices have collapsed. Although the price of gold relative to U.S. homes is not yet as high as it reached in the late 1970s, its current relative valuation compared to house prices leaves little optimism about the future potential for gold prices. Gold is also expensive relative to worker pay. In 2000, it took less than 20 hours of work (at the average hourly wage rate) to purchase a single ounce of gold. Today, by contrast, it takes almost 90 hours of labor to buy an ounce of gold! In a similar fashion, the price of gold relative to the basket of consumer goods and services comprising the Consumer Price Index is near its all-time record high reached in the early 1980s.
Finally, even compared to other commodity prices, the price of gold is nearing its all-time record relative price reached in the late 1980s. Even though commodity prices in general have increased significantly in the last decade, the price of gold has risen even more dramatically.
While valuation metrics have not traditionally been a good investment timing tool, they have provided a useful indication of the future upside/downside price potential of an investment. Relative to other investments, the charts in Exhibit 1 not only suggest upside is probably limited for gold but also cautions that downside price risk could be significant. At a minimum, these charts do not seem to support the widespread popularity and optimism concerning gold investing.
Gold and the “Fear Premium”?
Exhibit 2 shows the price of gold relative to other commodity prices. Although gold has been a spectacular investment since 2000, so have other commodities. Surprisingly, since 2000, the price of gold has only significantly outpaced other commodity prices during a few months in late 2008 when the “Great Financial Crisis” erupted. Between 2000 and late 2008, the relative price of gold to other commodities remained flat at about 1.5 implying both gold prices and other commodity prices rose by equal amounts during the period. Similarly, the relative price of gold was also unchanged between early 2009 and today. That is, “all” commodity prices rose just as much as gold prices between 2000 and late 2008 and again between early 2009 until today (despite this, however, general commodities remain a much less popular investment than gold).
The only time gold significantly outpaced other commodity investments was when investor “fear” surged. Exhibit 2 illustrates the “fear premium” the price of gold received relative to other commodity prices during the 2008 crisis and how much of this premium is still embedded in its price today. Between 2000 and late 2008, the price of gold oscillated in broad range about 1.4 times the value of the S&P GSCI Commodity Price Index. Today, gold trades at about 2.4 times the value of this commodity index. The risk or fear premium embedded in the price of gold (i.e., about 1.0, the difference between the relative price of gold today at 2.4 and where it used to trade prior to the 2008 crisis at about 1.4) is quite large and needs to be assessed when considering an investment in gold. A primary risk for gold investors is the potential for decay in this fear premium.
Gold’s Best Friend (Fear) May be Fading?!?
Exhibit 3 illustrates the challenge gold investors may face in the next few years should confidence slowly improve and “crisis fears” fade. This exhibit compares the relative price of gold to the Consumer Confidence Index. The confidence index (dotted line) is shown on an inverted scale so a rise (fall) in the dotted line illustrates periods when confidence is declining (increasing).
While not a perfect relationship, the relative price of gold relative to other commodity prices seems importantly driven by confidence. Gold’s best friend in recent years has been fear! As confidence collapsed in 2008, the relative price of gold far outpaced other commodity investments. Likewise, the decline in confidence after the tech wreck and after 9/11 in the early 2000s produced a similar “fear premium” in the relative performance of gold prices. However, between 2003 and 2007, the “fear premium” embedded in gold eventually evaporated once confidence again revived as the economic recovery matured. A similar revival in economic confidence may be emerging today. If the Consumer
Confidence Index does recover to at least 100 in this recovery, a good portion of the “fear premium” embedded in the price of gold may evaporate producing disappointing results for gold bugs.
Maintaining some gold exposure within portfolios makes sense. Should crisis fears continue to periodically flare in the next several years, gold should provide the portfolio with some defensive properties. However, we believe investors should consider reducing gold exposure. This is an investment which today seems far too popular among the masses, appears extremely overvalued relative to most other asset classes and faces a challenging environment should economic confidence slowly improve in the next several years. The valuation of gold relative to virtually any other asset class (stocks, bonds, real estate or commodities) seems to suggest the price of gold is either extremely rich today and at risk of significant decline or suggests most other asset classes are very cheap. Either way, it is probably time to position portfolios to benefit from a slow but steady revival in confidence rather than in an asset which only “glitters” when fear predominates.
Copyright © Wells Capital Management
Tags: Chief Investment Strategist, Commodities, Commodity, Consumer Goods, Diversification, E G Stocks, Glitter, Gold, Gold Price, Government Deficits, Historical Perspective, Last September, Luster, Price Of Gold, Relative Basis, Relative Valuation, Stock Market, Stock Price Index, Stocks Bonds, Time Peak, Valuations, Wells Capital Management, Wells Fargo
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