Backing
Into Success
A return to Critical Thinking
Over
the years we have met with many different kinds of investors. Some
were very knowledgeable, some had no clue, and unfortunately, most
seemed to be too busy to thoroughly understand their investments,
let alone the markets and economy. They relied on friends, TV, their
broker, but mostly it seemed they were relying on hope and luck.
And
during a bull market, maybe that is all you needed to be successful.
But now that it appears the bull market has ended, we have entered
a difficult period that requires much more research, experience
and a focused strategy.
Most
of what you hear from Wall Street tells you that you should start
an investment plan by picking the investments. You determine which
investments by whether you need income or growth, or some combination
of both. Your investments will then work according to your plan,
because…. they say so. Wrong.
Picking
the investments should be near the end of the process. Your own
investment needs, contrary to popular belief, are irrelevant to
what the market is doing. The market doesn’t care that you
need the XYZ growth fund to go up 10% annually for the next 10 years
so little Tommy can go to college. The market doesn’t care
that you are retired and need 6% income from your investments.
Instead
of Wall Street’s way, we prefer to “back into”
the investments. We look at the overall economy and markets, determine
what will benefit from what we see and eliminate those investments
that won’t benefit. What is left is a list of investments
designed to perform for the future, not some hazy hope of a repeat
of yesterday’s performance.
Below
is a summary of the steps to take to back into a successful portfolio.
First,
look at the big picture. It doesn’t take too
much research to uncover the current market and economic conditions.
This part takes little to no interpretive ability. The numbers are
the numbers. The direction of the charts speak for themselves. Below
are a few examples - The Dollar and Trade Deficit are declining
and interest rates, although still very low, are rising.
 
Source: Fed Reserve; Format: Cornerstone
Second
– Forget Wall Street truisms. This is a little
more difficult. Many investors and analysts have been brainwashed
with Wall Street’s mantras – "Buy ’n hold";
"Think long-term"; "You can’t time the market";
"Stocks always outperform" and so on.
Just
a cursory review of some charts show that these widely-held beliefs
are not true. History shows that stocks have had declines that lasted
years. They have taken decades to break-even. Many times, other
investments - bonds, cash, commodities - have out-performed stocks.
Not just in the short-run, but for years.
Buy
n' Hold didn't work here!
Source: Fed Reserve; Format: Cornerstone
Third
– Understand stock market and economic cycles.
This is more difficult and takes some analytical know-how. The vast
majority of investors are un-aware of the size of the cycles as
are many of the “experts” on Wall Street.
The
cycle is the key to investing success. Just like the change in seasons
has you rotating the clothes in your closet - winter stuff up to
the attic, beach stuff in the drawers - looking at the market and
economic cycles tells you which investments to put on. And these
cycles are measured in decades, not years or months.
Also,
just like the seasons, there are warm days in January and cold ones
in July, but that doesn’t mean the cycle has changed. Within
every cycle are countertrends that can last months and even years.
Within a deflationary trend, there can be inflationary countertrends.
Within a bear market, there can be stock market rallies. These don’t
mean the cycle has changed though.
Source: S&P; Format: Cornerstone
Fourth
– Asset Allocation and Strategy. Once you
have a grasp of the first 3 steps of this process, this part almost
falls into place.
Some
of it would seem obvious. It makes little sense to own bonds when
interest rates are rising. You would think by now everybody would
know not to own stocks in an overvalued market. (But there is always
someone out there that wants to tell investors that 2+2 = 5 and
unfortunately, too many investors fall for it.)
Next
are some key themes and trends and appropriate investments and strategies.
Declining Dollar – Own foreign bonds and equities.
They rise as the Dollar declines
Increasing/high debt levels – Avoid/sell corporate
debt. Avoid any bonds except the highest quality like Treasury Inflation
Protection Securities (TIPs) and AAA-rated insured municipal bonds.
Rising oil prices – Own oil companies, oil service
companies.
Rising inflation – Shorten bond maturities, own commodities,
own TIPs, have exposure to gold.
Over-valued stock market – Avoid/sell stocks. Sell
into strength. Review holdings and plan to sell any thing with a
P/E ratio well above its earnings growth rate (definition of overvalued).
Own hedges on the market and on particularly vulnerable stocks.
Rising L/T interest rates – Shorten bond maturities.
Eliminate lower quality bonds.
Low current interest rates – Do not own junk bonds.
Do not stretch for yield. Accept low rates. Low interest rates are
followed by higher rates. This could cause bond defaults and in
the best case causes the value of bonds to decline. Use capital
gains from properly allocated portfolio to make up the difference
for income needs.
Increasing Trade deficit –
Own foreign bonds and foreign equities.
By
looking at the condition of the market first, we fit the investment
to what the cycle is giving us. We don’t try to force investments
that don’t make sense. We simply eliminate those investments
that don’t perform well under certain economic conditions.
By investing according to the major economic themes, we automatically
diversify the portfolio into the appropriate investments.
The
fifth and last step – Question everything.
This does not mean deny facts in front of you. This doesn’t
mean to give equal weight to opposing points of view. (Contrary
to popular belief, one view is going to be wrong and the other right.)
This doesn’t mean to accept the easiest answers.
But do question the talking heads on TV. Question the standard line
from Wall Street. Question your advisor’s research abilities
or his sources of research. Question the logic of owning investments
that don’t match the cycle. Question the agenda of your advisor,
(an insurance guy usually has little to no research knowledge or
sources, a wire-house broker usually has to stick with company recommendations
and accountants are very good at taxes but most are not licensed
to give investment advice.) Question the nice marketing materials
from Wall Street and insurance and annuity companies.
We
constantly review our own positions and anticipate multiple scenarios
so that we have a plan in place before a change or target or event
happens. We know that there is no “permanent” portfolio
that can be put in place and then left on auto-pilot. As the cycle
progresses, trends and countertrends will develop that need to be
addressed. By having a plan in place ahead of time, we can anticipate
where we will be shifting assets instead of reacting.
Summary:
This can be more work than most people are prepared to do, not because
they are not smart enough, but because they are very busy running
their businesses, raising the family, living life!
But
this is what we at Cornerstone do everyday. By staying with a disciplined,
focused strategy, investors no longer have to rely on hope and luck.
They can be confident that we are relying on sound research, strong
fundamentals and something not found very often these days –
very critical thinking.
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