2013 Q4 Commentary: Investing in Uncharted Territory

Brown bears’ hunting techniques have been studied extensively. Handed down from their mother, brown bears adapt their fishing methods depending on yield ratios and salmon abundance in exacting fashion. Patience and context prove invaluable and determine the difference between those who thrive and those who are relegated to surviving off of the scraps down river.
Brown bears’ hunting techniques have been studied extensively. Handed down from their mother, brown bears adapt their fishing methods depending on yield ratios and salmon abundance in exacting fashion. Patience and context prove invaluable and determine the difference between those who thrive and those who are relegated to surviving off of the scraps down river.
“The less prudence with which others conduct their affairs, the more prudence we must use in conducting our own.”

-- Howard Marks’ favorite quote

As a portfolio manager, I have two jobs: 1) Define the playing field by understanding risk and 2) Once the playing field is defined, invest in opportunities that offer our clients the best risk adjusted return in order to achieve their goals. Last quarter we discussed our probabilistic approach in defining the playing field and understanding the dynamic of the risk/return tradeoff. This quarter I will update you on our thoughts on risk and share some thoughts on portfolio construction in light of these risks and uncertainty.

Understanding the Risk

If you read some of the mainstream media, you will see various professionals discussing what they currently “project” in the year ahead. The fact is that no one has been consistently effective at these predictions over a short-term time horizon. There are a select few however, who on rare occasions (usually at inflection points), offer what prove to be a prophetic view. This is not an annual ritual where they call a market top or bottom. It is rather, a well thought out argument that offers a departure from the mainstream, warning of outcomes that could cause the prevailing assumptions to be wildly inaccurate. Remember, all the hard work and planning in the world can be disrupted by one erroneous assumption.

Thanks to my good friend John Ritchie, I had the fortune to visit over lunch with one of the few exceptional economists/analysts, Woody Brock. Let me qualify this by saying Woody is a gifted thinker, a rarity in the economic world. Besides an independent mind of his own, he has three Harvard degrees, two from Princeton and he worked under Nobel Prize winning economists. He currently is a consultant to many of the world’s most influential organizations.

According to Woody, we are voyaging into uncharted territory:  26 quarters of 0% interest rates and more than $3 Trillion of debt monetization. The outcome:

We have seen at least a dozen ways in which today’s long period of very easy money and very low yields have distorted the workings of the financial system. This will cause unintended consequences in the near future…many of these will be adverse consequences. …It is not that monetary policy does not help, it clearly does. Rather it is that no matter how “easy” monetary policy has been, it will never suffice to generate a normal recovery on its own. We emphasize that this is theorem, not merely an opinion.

The great fallacy is that Monetary Policy on its own is the solution to our slow growing economy. It has only bought us time, however. Economic policy is a three legged stool and we are balancing on one leg. As soon as we get a rumbling in the form of a shock (either small or large) we risk falling off that stool as it wobbles. The second and third legs of Fiscal policy and Incentive Structure (regulatory) policy are severely lacking. The bottom line is that with a delicate economy and “distorted” financial markets, we have created a high level of uncertainty.

New York Fed President William Dudley adds little comfort with his admission at a recent economics conference that, “We don’t understand fully how large-scale asset purchase programs [QE] work to ease financial market conditions. There’s still a lot of debate…”

What? There is still a lot of debate?

If the Fed presidents don’t fully understand how these programs work, who does? The answer of course is that no one does. Few have written in depth about this with any degree of intelligence without referring directly to Woody and I am thankful of the opportunity to discuss this with him.

Portfolio Construction

A quick update on valuations (ie prices), which we discussed ad nauseum in the 2nd and 3rd quarters of 2013. With 10%+ earnings growth failing to materialize in the stock market as analysts expected, we are left with prices that are quite rich in nature. In other words, stock market gains have occurred as a result of investors paying more and more for earnings (ie higher multiples), rather than earnings growth. The major question for 2014 is: In light of significant economic uncertainty, will investors continue to pay more and more for lackluster earnings growth in hopes that one day the earnings growth will materialize? This seems like a game of musical chairs. Instead a quality constructed diversified portfolio should be grounded in sound values no matter the environment.

As part of a diversified portfolio we make decisions based on the following principles:

  • Bonds and cash are a critical component of risk management. They are not to be feared, but offer insurance when we see risk aversion and fear run rampant. This may be next month, next year or in three years. No one knows for sure, but the US dollar is and will be for some time to come the best safe haven against fear.
  • We will be much more likely to venture into areas where greater fear and aversion have led to much lower prices. Emerging markets fit that bill currently, but will surely be extremely volatile in the short-term. It is one of the areas that offer an interesting return and we will increase our exposure there as prices allow.
  • We will favor high quality, stable, (often times dividend payers) in a world where stocks are expensive or fairly valued. These companies have products and services that customers will demand no matter the prevailing environment.
  • We will look to invest in themes that are aligned with our investor’s goals, and managers who hold their long-term fiduciary duty to shareholders and clients as absolutely paramount.

Thoughts on the Market

We read a lot throughout the year. The following are some ideas that have shaped our thoughts as we begin 2014.


The chart at right from First Pacific Advisors shows that nearly two-thirds of gains from developed stock markets globally (except Japan) have come as a result of multiple expansion. For three years in a row analysts have “forecasted” much higher earnings growth than has materialized.

Consider that the recently awarded Nobel Prize went to Professor Robert Schiller of Yale University. Schiller has proven that the dynamics of asset prices are difficult to explain in the short-term and market participants are not always rational, which can lead to asset mispricing. Theory suggests that if an outcome of an event is more uncertain, investors will demand a greater return. We most certainly are in a time of great uncertainty, think of Christopher Columbus sailing into uncharted territory. Yet, investors are not demanding more expected return, in fact the opposite is true. Investors have driven up asset prices, which assures investors of a lower return in the future. This recency bias is quite common in cycles and whenever complacency enters the picture we jeopardize mispricing assets.

Renowned investment strategist, James Montier from GMO describes our current predicament, which he and many others have described as financial repression:

It’s not obvious to me that anyone has the perfect answer when you build a portfolio…trying to balance risk assets and safe-haven assets and maintain some vague degree of normality.

You can imagine two polar extreme outcomes: Central banks could end financial repression tomorrow. You would get real-rate normalization and the only asset that survives unscathed is cash. Bonds suffer, equities suffer and pretty much everything else suffers. Or, the central banks keep their rates incredibly low for a very, very long period.

The portfolios you want to hold under those two different outcomes are extremely different. I have never yet met anyone with a crystal ball who can tell me which of these two outcomes is most likely – or even which one could actually happen. You’re left trying to build a portfolio that will survive both outcomes. It won’t do best under either one of the two outcomes or the most probable outcome, but it will survive.

In summary, we do not pretend to know the outcome. We do not know which way the wind ultimately blows in the matchup between government debt accumulation, Zero Interest Rate Policy, QE~ and global currency wars versus, corporate and personal balance sheet deleveraging, aging demographics and the hollowing out of the middle class. Furthermore, our clients cannot afford to be wrong, as the deleterious binary impact would ultimately jeopardize their well-being, therefore we must be prepared for multiple outcomes. This guarantees that we will not lead the field. It does give our clients a much higher likelihood of success in achieving their goals. As mentioned last quarter, we are skewed toward lower risk, safer assets and therefore welcome a scenario of lower asset prices.