2014 Q3 Commentary: Heads We Win, Tails We Don't Lose Much

By Nick Fisher, Portfolio Manager and Rick Thomas, Business Advisor


With major stock market averages in the midst of a pullback, I thought it would be interesting to review the risks we have seen in the markets. As of this writing the S&P 500 dropped below its 200 day moving average for the first time in 477 days (third longest streak in history). Small cap stocks have been especially susceptible (down 13%+ on a price basis since end of June). This pullback is no coincidence, the stock markets domestically and internationally have benefitted from the global experiment of Quantitative Easing. Indeed the correlation of increasing stock prices in the midst of each round of quantitative easing is unmistakable. Likewise, the subsequent fall of stock prices, as each round has ended is distinct. Therefore, with the end of QE3+ on the horizon, there is no wonder that stock prices are under pressure.

The real question becomes: what happens next?

The answer: We have no idea.

Just as we have discussed in our last few newsletters, the Fed Reserve Committee themselves do not know what will happen next and whether there will be significant consequences as a result of this grand experiment.

“Even though many things can happen, only one will.” –Howard Marks

The risks at either end of the spectrum may be expressed: 1) Investor capital could become permanently impaired from taking too much risk, or 2) Investors run the risk of exhausting their savings from not taking enough risk.

Given the scenario of low interest rates, we must take risk, that being said, what risks should we take in our long-term portfolios? What scenario makes it attractive to take risks?

To answer this question, let’s continue our conversation on risk that we began a year ago with Howard Marks’ help from Oaktree Capital (see Q3 2013 newsletter).

The Fed’s Zero Interest Rate Policy has lowered returns on money markets, treasuries and high grade bonds to nearly zero. This has caused investors to flood into riskier assets in search of higher returns. This in turn causes ever riskier behavior and aggressive tactics, which causes standards in the capital markets to deteriorate. This can be contrasted using a simple capital markets line showing lower returns with similar risk (Figure 1).

The Fed has shifted the entire capital markets line downward by buying assets on the left side and investors have effectively flattened the line by selling assets on the left and buying assets on the right side in search of higher yield.

Investors are stuck with a range of possible outcomes with symmetric distribution (Figure 2).An equal range of outcomes are both better than average and worse than average. But, over the next 5-7 years assets on the right side have outcomes that could provide a negative real return (after inflation).

I was discussing this dilemma with my friend Eric Burnside and he brilliantly submitted the following revision describing the conditions under which intelligent investors make decisions. In this scenario the distribution or range of possible outcomes is skewed to the upside. The possibility of loss still exists but the number of outcomes and amount of loss is meaningfully less (Figure 3).

We would describe this process as one with a lopsided risk-return profile (an asymmetry of positive outcomes compared to negative outcomes). Or as Mohnish Pabrai describes it: heads I win, tails I don’t lose much.

As markets correct in the coming days, months or years, we will seek out this asymmetry. A chief assumption is that we know what we own, so that in a worse-case scenario, we can limit a permanent loss of capital. Valuation is paramount in this conversation, as Marks puts it, “…the best way to reduce risk is by paying a price that’s irrationally low…a low price provides a margin of safety…all you have to do is refuse to buy if the price is too high given the fundamentals.” Investors often forget how volatile markets can be during the month or quarter and in the absence of this perspective they feel they must participate regardless of valuations (See our Q1 2014 Commentary). Opportunities will present themselves, but we are not forced to swing at every pitch and there are no called strikes. We will wait for our pitch.

While investor behavior is nowhere near as deleterious as it was just before the financial crises, it does inspire caution. According to Robert Schiller (Nobel Prize winning economist), people are contradictory, just as the market was increasing in 1999 and investors thought the best place to be invested was in stocks, investors were losing confidence in the valuation of stocks.

I submit we are in a very similar world today.