We are facing a crisis of confidence. Investors are becoming increasingly unsure as to where to put their hard earned dollars for long term growth and preservation of capital. The historical mantras of buy and hold or diversification among style boxes and asset classes, has done little to protect investors from incurring significant losses over the past decade; and the reality is we may have a number of years remaining in this secular bear market. We as investors find ourselves in a historically unique position.
Early on in this industry, or in our academic studies, many of us learned about the efficient frontier (a historical model illustrating capital market assumptions and the risk/return dynamics of general asset allocations). Essentially what this model teaches us is that the greater the risk an investment has, the greater the volatility, the greater the returns over time. Ironically, what we may be seeing now is an unwinding of the tenets behind this theory.
Consider the following: traditionally an investor with an asset allocation of 30% stocks and 70% bonds has been viewed as very conservative. But today, this represents an allocation overweight to the most expensive asset class – at its most expensive point in history; during a period in which monetary policy has brought interest rates to near zero and flooded the markets with more and more debt (historically this has lead to inflation, but perhaps deflation first). Even still, conservative investors today are willing to lock in less than a 1.5% annual gain for 10 years, in what today is still viewed as the ultimate flight to safety – the US Treasury Bond. And yet hardly anyone would suggest that over the coming decade we will see inflation rates less than 2-3%. So effectively, this conservative investor is actually locking in a loss on 70% of their investable assets!
On the surface it appears to make little sense, but what it speaks to is the heightened levels of fear and uncertainty in the global equity markets. So again I ask, if you are allocating dollars for long term growth – where can you put it and expect a reasonable return with limited downside risk? Or for those already exposed to long positions in risk assets – how can you reduce the risk in your portfolio without giving up potential upside from here; after all we still have not even clawed our way back to the highs made in the US equity markets back in October of 2007 (when the Dow reached its all time high of 14,164.53).
Many of the most well respected and prominent figures in our industry have widely discussed what they believe will be a more difficult investment environment in the United States and abroad in the coming years. PIMCO has coined this environment as “the new normal” – a period of slower, more muted growth, and more frequent recessions. Others have framed the years ahead as “the great deleveraging”; as developed countries around the world will be forced to take measures to pay down the massive debts incurred by trying to prevent a global depression during the Great Recession of 2008. This will lead to societal changes unlike that which we have seen in the past, as simultaneously governments and individuals alike aim to reduce debt. In this environment, many believe wage growth will be slow as corporations and small businesses adapt to lower levels of consumption (and potentially higher taxes). Unemployment is also likely to remain above historical norms. With increased uncertainty and businesses operating lean, why hire more employees when the ones you have are just thankful to have a job and are managing a workload previously assigned to two people?
In the United States specifically, we are potentially faced with decades of demographic challenges. In the US, nearly 30% of our population is comprised of the Baby Boomer Generation (those born between the years of 1946 and 1964), and yet this demographic controls more than 40% of consumer spending. As these individuals grow older, and move on into retirement, they are going to place increased strains on our current social programs (i.e. Social Security, etc.). These programs are already under pressure and woefully underfunded; imagine the impact it might have when this entire generation is retired! This generation controls the largest percentage of financial assets in our country, as such they have incurred the biggest losses over the past decade. How might the spending habits of this generation change in retirement and what impact will this have on US GDP, 70% of which is historically comprised of consumer spending? No one can say for sure, but suffice to say these are valid concerns and questions to which we as of yet have no answers.
These aforementioned challenges will move structural reform to the forefront in the coming years, as political leaders grabble with how to get elected, but at the same time present a framework for “righting the ship”. We are already seeing this now in the United States, with discussion of the upcoming “fiscal cliff”; as the Bush Tax Cuts are set to expire at the end of this year. What would happen if during a time of economic instability, with the world teetering on cusp of recession, taxes were increased in the world’s wealthiest nation? Common sense will lead you to deduce consumption would go down. Perhaps increased selling would take place in assets held long term, as investors seek to recognize gains at a lower tax bracket today then they will recognize next year, or in the foreseeable future. Even the FOMC (Federal Open Market Committee) has come out recently and stated that if the Bush Tax Cuts are allowed to expire, the US will enter into a recession in 2013.
As fiduciaries for our clients, with good intentions of providing sound investment advice that will assist them in reaching their goals – I contend the environment we are facing is going to make our jobs that much more difficult. Specifically, with all that investors have experienced since the bursting of the tech bubble, collapse of the housing market, and the Great Recession – I personally don’t believe many investors will have the intestinal fortitude to stay the course very long when our next “crisis” presents itself. The vast majority of investors have come nowhere near recouping their losses from previous downturns, and I fear the proverbial line in the sand will be drawn quickly.
Making the wrong call now, during such a fragile period in the global markets, can have a significantly adverse impact on our client’s long term goals. It only makes sense, that as investment professionals we begin to shift our focus to risk adjusted investing; presenting our clients with a defined strategy and discipline for avoiding outsized losses from which they may never recover, or at very least that may make a profound impact on their future goals.
