XXX
A Review, an Outlook and the Emergence of New Investment Theories
By William Parmenter, editor
David Wright, principal, Sierra Investment Management, Inc., spoke on “A Review of 2010 and the Outlook for the the New Year: The Emergence of New Investment Theories“ at the Jan. 15 meeting of the Los Angeles chapter of the AAII at the Skirball Center. The audience was the second largest ever to attend a Los Angeles chapter AAII event.
Wright is well-known to the Los Angeles chapter members, as he and Tom Petruno, of the Los Angeles Times, speak each January to inaugurate the new investment year. Wright served on the board of directors of the Los Angeles chapter for over 20 years.
The topics covered in Wright’s presentation included: investment trends in 2010, key trends in the economy, evolution of new investment theory, rethinking asset allocation and buy and hold, and an update on the Sierra Core Retirement mutual fund.
Wright opened his remarks by commenting on the ferment in the investment industry. The old approaches have been exposed as deeply flawed. In a major transition in the investment field, new investment theories are evolving out of the wreckage.
During the first eight months of 2010 stocks moved horizontally and T-bonds soared, as interest rates declined. The S&P 500 declined from a base of 100 to 95, while PIMCo Institutional Long-Term Government Bond rose from a base of 100 to 125. (The funds and indexes cited are Wright’s evidence for his generalizations.)
In the final four months of 2010 stocks trended up from a base of 100 to 117, even as interest rates rose, which is quite unusual. Meantime, long-term T-bonds dropped in value from 125 to 110.
Over the last 12 months high-yield corporate bonds offered a superior risk/reward tradeoff. Northeast Investors Trust, offered less volatility, and rose from a base of 100 to 115. (To see the charts of Wright’s slide show go to the chapter website at www.aaiilosangeles.org. and on the home page, in the left-side rail column, click on Presenter’s Slides.)
Floating income funds were good diversifiers in 2010, insensitive to the reversal in interest rates. The PIMCo Institutional Floating Income Fund rose from a base of 100 to 108.
Emerging market bonds had another good year in 2010. SEI International Emerging Markets Debt fund rose from 100 to115.
Global commodity prices, another risk asset category, had a very strong recent
Table of ContentsReview and Outlook for 2011……...Dave Wright……p.1
Investing Horizon for 2011…....Tom Petruno………..p.6
Education Nuggets………..Don Gimpel………………p.8
correlation to the stock market. Rydex Commodities Strategy fund started the year at a base of 100, dropped to 82 in late May and rose to 106 by the year’s end.
The U.S. dollar rose for about six months, then declined. The ProFunds Rising U.S. Dollar fund started at a base of 100, rose to 112 in June and dropped to 98 by year’s end.
Addressing key trends in the U.S. economy, Wright noted that the markets spoke in the fourth quarter of 2010, and proclaimed that QE2 is not the answer. Monetary policy has no weapons left, and fiscal policy has stalled. The question of the day is: will the economy develop self-sustaining growth? Or will the months ahead begin another downturn into recession?
The key factors to examine are employment, consumer attitudes and consumer behavior.
In a cartoonish simplification by Daryl Cagle of MSNBC.com.: the Fed and the Treasury were on the job—while housing was under water, the Fed dropped short-term interest rates to zero, and the Treasury indiscriminately dropped bags of money. Question: who is going to pay?
Some parts of the economy are in deflation, the first such episode since the 1930s. Fiscal stimulus helped the economy a bit, but it was not enough to ignite a self-sustaining recovery.
Cash for clunkers, and mortgage subsidies, have expired, and borrowed growth from future quarters. The corporate inventory rebound was not sustainable and now it is over.
Housing prices rallied nationally, but now are heading down again. As a result of the recent drop in real estate prices, as well as lower interest rates, the median U.S. home is as affordable as it was in 2000.
A “new normal” for the economy has emerged. Among the new normal features are the following: large deficits, and federal/state/local/consumer debt levels are now structural burdens on GDP growth. GDP growth now will likely average only 2 percent or so per year, compared to a 3.2 percent post-WWII average.
State and local governments will greatly reduce services. The federal government will likely reduce some entitlements.
Consumer spending has slowed, because many have less to spend. Households have shifted to net savings and being cautious, after almost 25 years of spending beyond their means.
Unemployment, currently at 9.4 percent, is structural, will last indefinitely, and is not a part of a normal post-WWII cycle.
Jobs will be hard to get for at least the next five years. People over 50, who lost their career jobs, are probably either out of the work
Los Angeles County Meeting ScheduleWestside Computer Group – Don Gimpel, 310/276-9875 . Veterans of Foreign Wars Memorial Bldg. Culver Blvd. & Overland Avenue, Culver City. Will meet at 10:30 a.m., Saturday, Feb. 5. Topic: Views of the Future. The UltraFS 11 group will meet at 9 a.m. on the same day.
Pasadena Group – Meets at 7 p.m., at Pasadena Main Library, in the David Wright Auditorium, at 285 E. Walnut St., Pasadena. (Meets third Tues. of the month, except for August and December.) Topic TBA. Voluntary contribution of $2. Contact, Ivan Wong at (626) 446-2486, .
Mutual Fund Group – Meeting at 10:30 a.m., Saturday, March 5, Speaker, Gil Tong, at Morgan Stanley Office, 1453 Third Street, Santa Monica. Gunter Hagen 310/457-7404, . The meeting is free to the public
Stock Selection Group—Norm Langhout, 310/391-6430, . Fourth Wednesday of the month at 7 p.m. Using IBD, CANSLIM stock selection method at Fairview Library, 2101 Ocean Park Blvd., Santa Monica. Topic TBA
Los Angeles Chapter Skirball Center at 9 a.m, Sat. Feb. 19, “Managing Risk in the Global Capital Markets,” by Steven Abernathy and Brian Luster, managers, The Abernathy Group, LLC; and “Conquer the Greatest Money Migration in History,” by Keith Fitz-Gerald, CTA, Chief investment strategist, Money Map Press and Money Morning.
Desert (Palm Springs area) Group Usually meets from 10 a.m. to noon, second Saturday of the month at Sunset View Club House, Sun City, Palm Desert. For more information, contact Patricia Gammino, .
Option Special Interest Group, meets Saturday, 9 a.m. to noon at Westside Pavilion, Community Room A, 10800 W. Pico Blvd. (corner of Westwood Blvd.) Time and topic TBA by leader Robert Morgan, .
force for good, or employable at much lower salaries.
“Full employment” will not be achievable until the U.S. develops several new industries. There has been no sign of that in the last 12 years.
Higher gas costs will force people from remote suburbs back into inner cities, and further erode their disposable income. On the bright side, inner cities could be revived.
Lower growth rates will extend the unemployment pains.
The recovery in employment remains sub-par, below the growth rate of the economy. In the ten recessions since WWII, the recovery of the current recession was characterized by the greatest percentage of job loss, and the greatest number of months to recover.
Currently we are 27 months out from the inception of serious job losses, and the recovery is just started. In eight of the previous recessions jobs were fully recovered by now. And, it is not enough to recover the eight million fulltime jobs lost, the actual goal is to recover the percentage employed, as the work force is constantly growing.
Over eight million jobs were lost in the last decade, while the labor force grew by 10 million. In the decade of 2000 the labor force shrank by one percent. In the decade of 2010, so far the labor force has grown by one percent. These figures contrast with the labor force growing an average of between 20 and 40 percent each decade between the 1940s and the 1990s.
Stock prices have risen to the point that they are risky now, making further job gains problematical.
It will take “forever” to get back to full employment. The problem is structural. The economy will have to adapt to high unemployment.
Wright turned his attention to outworn investment theories developed over the past 35 years, and the emergent thinking to replace them. Several Nobel prizes for economics were awarded for the formulation of these theories.
Efficient Market Hypotheses (EMH).
Modern Portfolio Theory (MPT); and the Efficient Frontier.
Capital Asset Pricing Model (CAPM).
Cap-weighted index mutual funds.
Among the tenets of these theories were the following:
Future average annual returns are likely to be similar to past average returns.
Asset class performance over the long term will tend to revert to the past mean.
Price performance for future periods will vary but in standard Gaussian bell curve distribution.
Investors will behave rationally at all times.
Assets will be priced rationally, on a daily, and hourly, basis.
Brokers and other financial advisors have relied on short, simplistic and sometimes deeply flawed ideas: Among these ideas are:
They relied on a limited number of asset classes: the S&P 500, U.S. Treasury bonds, and cash (90-day Treasury bills).
They believed that “efficient” portfolios could be created, based on risk/return diagrams.
They believed that a portfolio could be “efficiently” constructed, to match a given client’s risk tolerance.
They believed that once an “efficient” portfolio was constructed, the best strategy was buy and hold.
The ugly truth is these theories have proven to be deeply flawed, given the events of the last 12 years. Some of these events included:
Unusual occurrences have happened three to four times as often as the models would predict.
There are three to four times as many large daily moves in the S&P 500, for example, than Gaussian distribution would predict.
There are sometimes black swans—unprecedented events and huge moves in prices of some assets. This has been a most important factor.
Investors do not always act rationally. Both professionals and individual investors sometimes follow the herd.
Risk mitigation is the new normal. Many investors sell when they are scared, accelerating downward movement of prices.
Two to six months is the new average holding period for New York Stock exchange stocks, compared to the former eight to nine years holding period.
Conversely, it turns out that many investors, including computer-driven robots, are momentum driven; they buy assets whose prices are rising, regardless of fundamentals.
There has been a failure of Efficient Market Hypothesis, Modern Portfolio Theory and Capital Asset Pricing Model. Each of them failed to predict any of the problems of the past decade, and cannot explain them even after the fact.
Far too many unexpected, large price swings occurred.
They provided no understanding of the difference between risk and uncertainty. Risk can be quantified, based on frequency and magnitude of past occurrences. Uncertainty has to do with things that cannot be anticipated, the “known unknown” and the unknowable.
The biggest lie of Modern Portfolio Theory: the risk-return diagrams in pervasive use for the past 30 years plot historical average returns, past returns, against risk. William Sharpe won the Nobel Prize, in part, however, by showing that future returns of an asset class, even on average, over the long run, are NOT predicted by past returns.
The biggest lie came about when many firms in the investment industry nevertheless relabeled the vertical axis on the risk-return diagrams as “expected return.” “Expected returns” contradicts the idea that past returns cannot be used to predict the future. No one knows what the future will bring. The future is fraught with uncertainty.
The flawed theories brought wreckage to the investment landscape: it was goodbye and sayonara to Merrill Lynch, Lehman Brothers, Bear Stearns, AIG, Citicorp, Fannie Mae and Freddie Mac.
Tragically, tens of millions of Americans, particularly retirees, were devastated by the implementation of these flawed theories. Many households will never recover their losses, and retirees, who could not go back to work, suffered crippling reverses.
Some investments made it through the financial meltdown. For example PIMCo Total Return had a smoothly ascending slope of returns over the last 22 years, moving from a base of 100 in 1988 to about 680 in 2010. Conservative investors, invested in PIMCo Total Return did not have to undergo the ordeal of the roller-coaster ride that the S&P 500 went through.
Long-term U.S. Treasuries outperformed the S&P 500 in the last decade. The Vanguard Long-Term U.S. Treasury fund went from a base of 100 in 2001 to 180 in 2010, while over the same time period the S&P 500 went from 100 to 118. Was that a lost decade? Or did Wall Street simply over-emphasize equities?
The question of expected return has been investigated by Jeremy Grantham, at GMO since 1990. He has found out that when the price is higher than fundamentals would historically dictate, it is virtually certain that future returns will average lower than past averages.
He has found the reciprocal also to be true: when an asset is priced lower than historic norms, based on fundamentals, it is likely that future returns will average higher than past averages.