“I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”
James Carville, former aide to President Bill Clinton, made this famous quote in 1993. This twenty-year old statement rings true today as all eyes have fixated on the recent rise in interest rates. However, we believe that Mr. Carville would revise his statement today. Rather than reincarnation as the “all powerful” bond market, many today would suggest returning as the Chairman of Federal Reserve. Ben Bernanke can intimidate everyone because his position controls the most powerful monetary tool in the world—a virtual printing press of U.S. Dollars.
Whether you agree or disagree with Bernanke’s use (or misuse) of the Federal Reserve’s policy tools, it is impossible to debate the Fed’s influence over markets. Bernanke’s recent suggestions that he would “taper” bond purchases (currently running at $85 billion a month) sent global investments sharply lower in a “taper tantrum.” Bernanke reversed the decline and sent markets surging with his recent clarification that “you can only conclude that highly accommodative monetary policy for the foreseeable future is what’s needed in the U.S. economy.” The market’s behavior of recent weeks simply reiterates the market’s conclusion of recent years—Central Banks (temporarily) rule the world.
Given the trillions that current Fed policy has required, it is likely that policy makers will err on the side of ending accommodative policies “too late” rather than “too early.” Pundits and strategists suggest ignoring monetary policy and focusing on the “fundamentals.” However, it is impossible to analyze economic and market fundamentals independently as fundamentals have been distorted by extraordinary monetary policy.
Even Ben Bernanke concedes in his speeches that the present policy course is not sustainable. Unfortunately, many investors have been lulled into embracing belief’s on both ends of the spectrum—either the belief that things are back to normal or the belief that Bernanke is completely in control. We can forcefully emphasize that the current monetary addiction is not normal, and that Central Bankers cannot control all of the consequences and side effects of their unprecedented experiment.
How should we invest through and around these extraordinary conditions?
1. Embrace a multi-asset portfolio.
When most investors think about the “markets,” they are thinking about the S&P 500 or the stocks of large U.S. companies. This is a very narrow view of a growing, global investment opportunity set. Portfolios with “global breadth” will include U.S. Stocks, International Stocks, Real Estate, Natural Resources, U.S. Bonds and International Bonds. Further diversification through “asset class depth” expands the reach of an investment portfolio into sub-asset classes such as small cap stocks, emerging markets, commodities, and corporate bonds.
Strong 2013 U.S. stock performance is masking weak 2013 performance across several asset classes. Opportunities will emerge in currently underperforming asset classes as Central Bank policies make possible a wide range of economic scenarios, ranging from deflation to inflation. Each asset class plays a unique role in the long-term mandate to build and protect wealth. Abandoning diversification may be compared to benching an offensive lineman because he has scored fewer touchdowns than the running back.
2. Recognize “dynamic or tactical strategies” as an additional diversifier and risk management tool.
A core, multi-asset portfolio can be supplemented with investment strategies that adapt as market conditions change. While some asset classes will have periods of higher correlation to each other (move more in tandem), carefully implemented investment strategies can change asset class exposure in a way that reduces correlations and manages risk. Investment strategies have the potential to act as growth engines or volatility reducers within a broader portfolio.
It is noteworthy to remember that risk is never completely eliminated, and that using an investment strategy simply changes the form of that risk. Introducing tactical or dynamic strategies into a portfolio simply transfers the risk from the “market” to the “strategy.” In its correct proportion, this is a valuable and important transfer of risk
3. Reduce the probability of behavioral mistakes.
The most damaging investment mistakes are behavioral. The tremendous noise that surrounds public policy and financial markets can create emotional reactions that lead to sub-optimal investment decision-making. Successful investors are “self-aware.” They recognize that emotion crowds out objectivity, and they recognize the media, relationships, and behaviors that trigger emotional investment reactions. A steady diet of CNBC or a too frequent review of portfolio balances will lead to a variety of emotional investment disorders. Objective investors are amused rather than concerned by the tall tales and miraculous investment conquests shared at the water cooler or at dinner parties. So many half-truths and outright investment lies are told in these settings that repeating them would cause even Bernie Madoff to blush.
Many behavioral mistakes stem from a lack of understanding of market history or of market reality. Mark Twain must have been in an investing conversation when he stated that “history does not repeat itself, but it does rhyme.” Market history can give us valuable context and perspective on what attributes (volatility and return) to expect from different investments. The possibility of behavioral mistakes are reduced with a healthy dose of self-awareness, with a general grounding in market reality, and with a sound understanding of the design, attributes, and objectives of his or her investment portfolio.
While today’s macroeconomic and market challenges appear daunting, investing will always include a healthy dose of uncertainty. Central Banks will always have an impact, but we should remain particularly guarded during this period of extraordinary policy experimentation.
While none of us can control the ultimate outcome of the Fed’s policy experiment, we strongly believe that the three items outlined above—embracing a multi-asset portfolio, including dynamic strategies, and avoiding behavioral mistakes— best position an individual for sustained investment success.
Lunt Capital Management is a Salt Lake City-based investment advisor and manager with institutional and individual clients.
