Bonds versus stocks?
August 30th, 2010
Bonds or stocks? A nice investment this year has been the bric versus BRIC trade. Since I wrote about it, long Colombia/short China returned +50%, long Indonesia/short India +30%, Bangladesh bettered Brazil and Romania rose past Russia. Beta-neutral relative value emerging market strategies usually don’t make money on both sides. While economic expansion does NOT imply stock market growth, I’m more glad I didn’t tie up peoples’ cash in “risk free” cash. Long only? Too risky so I’ll leave others to chase the bond bubble. Absolute return is the SAFER alternative.
Seek alpha or bet on beta? Why does so much financial advice fixate on how much to allocate to various betas? The more “risk averse” the more in bonds? Is it sensible to recommend the same allocation at 1% yields as when they paid 10%? Can opportunity cost and default risk be ignored with coupons so low and borrowing so high? There are NO risk free bonds but at least higher yields did deliver the fixed-income on which so many individuals and institutions depend. Financial reform and regulation has as much chance of preventing the NEXT crash as ordering the ocean to stop rogue waves. Get sunk again OR benefit from them? Investors can choose.
Many suffer from Anton’s syndrome. They think they can see but they can’t. The mind confabulates a vision of smooth-sailing for their portfolio. Investment inertia and the endowment effect favors what they own not what they should own. Those with a chronic case delude themselves that some “efficient frontier” combination of stocks and bonds can achieve +8% CAGR over the long term! Market timing is “impossible” so buy and hold for the economic utopia they can see but blind people like me cannot. Security analysis is a waste of time so buy “all” securities despite the FACT that 75% of stocks are long term lemons. Whether inflation, deflation or biflation, own bonds as the 60/40 portfolio is “optimized” for all yields, risks and default probabilities? Buy even more bonds if you “see” yourself as “conservative”! And there is NO risk if you hold stocks long enough?
What if your required return is much higher? With 2008 rapidly being forgotten and falling off track records, asset class amnesia is hazardous but financial anosognosia is worse. To have a defect is bad but to not know you have the defect is dangerous. The world divides into the few that know they don’t know and the many that don’t know that they don’t know. Famous clairvoyants sell their “vision” that everything will be fine one day. Hopefully passive stock and bond portfolios won’t die before then. How many planned retirements and retirement plans have been wrecked by long only index funds? Too many. A bond bull market is almost as bad for liability matching as a stock bear market! The pension underfunding crisis is considerably worse discounted at CURRENT government and corporate bond yields.
I’ve researched many successful investors and one common factor is that none paid attention to asset allocation. Instead they selected securities and/or timed markets. I also studied many unsuccessful investors and found they put asset allocation front and center. Conclusion: 1) asset allocation only drives returns if you DECIDE to emphasize it, 2) why waste time on something that the best don’t? Better to have the entire portfolio in skilled strategies. Selecting which betas to track, then searching for managers to deliver it (and maybe a bit of alpha) hasn’t worked. What does work is to choose good unconstrained managers and let them figure out how to produce absolute returns. Portfolio lifeboats include puts, shorts, derivatives and most importantly ALPHA for when beta inevitably hits the iceberg. Again. Index funds are like the Titanic; unsinkable till they do. So hedge.
Asset allocation varies by age? High opportunity cost putting capital in low yield securities. Bonds are good to trade but not buy and hold anymore. There are no stable laws in finance. Conventional wisdom was to put one’s age in “bonds” and the rest in “stocks”. But the rapidly growing cohort of centagenarians needs an adequate income too. Why should a 20 year old have 80% in stocks? Because equities supposedly rise if you own them long enough? The switchover from stocks to bonds over time doesn’t cut it. More sensible is to have 100% of the portfolio in alpha opportunities. The bond bull market has persisted for 30 years.
Portfolio dead weight? High grade bonds are considered to be a liability match. They were once but now they are not. More a liability mismatch. A flat to down equity market combined with lower interest rates is not positive for underfunding. If you need an +8% income you can bet on “high” yield junk bonds, hope the stock market will deliver that “expected” return or focus on SAFER alternatives. At such low yields, every cent in “risk free” bonds is a wasted chance for better risk-adjusted performance. Also not enough bond buyers are worrying about return OF their capital. There are superior investment opportunities available. The attraction of skill-based strategies rises directly as a function bond yields.
Keep it simple investing? Occam’s razor? The only bar in William of Occam’s home town is called The Black Swan. Simplicity requires preparing for the worst case, most “unlikely” situations. I don’t worry about unlikely events happening. I presume they are imminent and act accordingly. Every investor should apply a PROPER stress test to their portfolio. Instead of VaR, assume all stocks, bonds and real estate are worth ZERO tomorrow morning. Preparing for the doomsday scenario is true risk management. It has happened several times in many places in the past. That is not economic eschatology; it is prudent fiduciary duty. How many investors are ready for a 90% global stock market crash and widespread debt defaults? If not why not?
Someone asked my forecast for the Dow 1 year from now with 90% confidence. My best guess is between 0 and 20,000. That is as tight a bid-offer spread as I can manage. Predictive accuracy declines exponentially with time. While the Dow might never see 20,000 it is a physical and astronomic CERTAINTY it will one day fall to zero. Before then there are numerous armageddon scenarios that would nullify the stock market. Just takes a few drunken generals or mad scientists accidentally pressing the big red button. How do you know a large asteroid isn’t on its way here? What would assets be worth if a black hole from a Magnetar was discovered headed towards us? If it can happen it will happen is not a prediction, it’s a philosophy. Buy and hopers should remember that they are betting AGAINST the inevitable end-game. The true long term drift is down.
Risk management? Thinking the unthinkable is an essential requirement for portfolio construction. The recent “flash crash” was a reminder of the ephemeral “value” in the markets. It came back, that time. 2008 offered a valuable and expensive investment lesson for risky long only but still some invest in index funds. Two -50% drawdowns in a decade and MUCH worse coming in the future. It’s the notorious Dunning-Kruger effect. Many people think they are smarter than they are which is why we get bubbles and crashes. Unskilled AND unaware of it. Scarier than a real black hole but with similar results.
Invest in alpha opportunity sets. How much to allocate to “emerging markets”? How much to “submerging markets”? So many countries, cultures and disparate outlooks for all those stocks, bonds, commodities and currencies. “Frontier markets” don’t have long track records but weren’t all countries “frontiers” once? The China economy is larger than 3 years ago but the stock market is over 60% below its high water mark. The Japan economy is bigger than 20 years back but Nikkei 75% off its high. Plenty of Chinese and Japanese securities are doing well as are the good hedge funds that focus on finding them and short ideas. How much should you allocate to “hedge funds”? Every investor needs 100% in skilled strategies at that requires a lot of analysis and due diligence.
Search for yield? A few months back many experts said inflation was inevitable so short bonds but now deflation is the hot topic so buy them instead? A long list of gurus have lost big money shorting JGBs over the years but now treasuries are doing the same. If you need an explanation for the rally it is as much a short squeeze than flight to “safety”. Trade bonds but don’t hold them. Just like stocks. Applied skillfully, long/short equity is safer than long only. And I’ll take thoroughly analyzed long/short credit, fixed-income arbitrage and distressed debt strategies over unhedged bonds every time. Some returns DO compensate for the risks.
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