Why Diversification is Temporarily Broken: A What to Do Today Tale

Posted by Carlos Sera on Dec 23, 2015 9:32:00 AM

diversification.jpgThis tale is a major departure from my other tales.  The last time I actually made a market call was in October of 2008.  It was a bullish market call since it was clear to me that stocks were cheap, quality Blue Chip stocks were paying high and sustainable dividends, and the future of the stock market would be one of reduced volatility. 

We were temporarily experiencing mayhem but it would pass as history has taught us.  The types of opportunities that existed in late 2008 are rare but when they happen you must take advantage of them.   (Link to Video)

Here’s another market call.  (You can see from how long I go between market calls that I am not one to cry wolf.)  This is a bearish market call, and the strategies that worked from 2008 through today are not the ones that will work until this period passes.  It’s why diversification is temporarily broken.  Please note, diversification will come back in fashion but for those that understand investing, it is just one style of investing and like every style we’ve analyzed, it too has periods of underperformance and one is coming up.      

Please note, a complete investment strategy recognizes there will be periods of stock over and undervaluation.  It recognizes there will be periods where the markets don’t cooperate and so it must be adaptable to market conditions and more importantly to individual investor behavior.  Our readers know we are not fans of diversification as an investment strategy, primarily because it has periods where it produces very large losses and these large losses cause investors to make irrational decisions. 

These decisions are more often than not to their detriment.  The last 30 years of working with investors has taught us most people are incapable of withstanding the losses associated with diversification and are even more incapable of executing the types of rebalancing trades that the strategy requires.  Once again, we also know there are periods where diversification appears to be a loser’s strategy, such as today.  I suggest you read A Practical Tale to understand that diversification amongst equity asset classes is a myth.        

What’s our market call?  Stocks are not cheap, the internal sentiment indicators we follow are turning negative, and when next we see a sharp drop in stock prices, we expect a sharp drop in all equity asset classes.  Furthermore, with bond and cash rates at extremely low levels, we don’t expect a traditionally diversified portfolio of stocks, bonds and cash to earn investors more than 1-2 percent over the next decade. 

In fact, we expect clients that pay their advisors 1-2 percent to manage their money may witness their advisor making more money than they do. 

There are solutions, but they require one of three things, 1) The ability to trade successfully, 2) A more concentrated portfolio than what diversification calls for or, 3) some type of hedging strategy.  If you don’t have one of these solutions in your arsenal, expect the worst. 

If you are fine with 1-2 percent over the next decade or think my forecast is wrong, then continue what you are doing.  If you are not or might have a suspicion that something just isn’t right, the rest of this tale and the links I have provided to other tales will be of interest to you.  Please note what a 1-2 percent forecast means.  If you have $100 today, a decade from now, you will have between $110.46 and $121.90.  A year from now if we see the market has dropped 30 percent your $100 would be worth $70.  What does someone that invests the $70 at that time make over the next 9 years?  They make between 5.20 percent and 6.36 percent.  Timing matters and people should be cognizant of where we are in market cycles and this one has us near a top.

Let me digress, when I write a tale, I intend for it to be evergreen.  Evergreen means I want someone that may read a tale at some distant date to be able to absorb relevancy from what they read.  It should not be situational to the times, investment climate or economic conditions.  In my tales, I also refrain from giving any type of specific investment advice, because everyone’s situation and risk tolerance is different, and the objective of these tales is to teach you to think for yourself. 

This is not investment advice; this is a sign of the times and one should always be aware when they are in extreme scenarios such as this one with internals breaking down.

As our readers know, we are strong advocates of the combination of momentum with technical analysis as the easiest way to capture both superior returns and reduce risk in all types of market conditions.  Of the three possible solutions to the impending stock market downdraft, our solution is to trade successfully.  We may not always accomplish our goal but you can get a glimpse of our approach by reading our whitepapers

Our readers should also know, we would not be in the money management business if our investment philosophy were to simply invest money in a diversified portfolio of stocks, bonds and cash.  Diversification is a commodity at this time and there are thousands of options available to consumers to do it themselves.  I would never pay an advisor premium prices for a commodity solution; this is today’s environment.  As clients of advisors that provide cookie-cutter diversification services become more educated, we expect there will be a fundamental shift to advisors that provide value as well as to do-it-yourself solutions.  The days of the “Know nothing, Buy a bunch of things and Rebalance” advisor is ending. 

Fortunately, we are in this business because what we offer is unique and we expect it to work, today, tomorrow and into the future.  Our investment approach is evergreen and designed to be evergreen.  It is a function of human nature, and the way money flows as a reflection of crowd psychology.  Our approach is to view markets and investing as a “complex adaptive system.”  This means, our approach is an approach where individual asset class selection is not as important as trading techniques and risk control measures.  Said differently, we are traders and our trading techniques are technical in nature.  While we pay attention to fundamental and economic conditions, fundamentals do not tell anyone when to buy or sell or more importantly, how much to buy or sell.  Our approach tells us when to buy, when to sell and how much to buy and sell. 

How does a technical perspective differ from others and why should you develop an investment model you can execute?  Let’s take an example everyone is discussing.  Recently the Federal Reserve raised interest rates for the first time in close to a decade.  What does this mean?  I use it as an illustration because events will happen throughout your investment career.  What it means to a fundamentally driven analyst is very complicated with all kinds of “what if” scenarios.  Someone with a macro perspective is off running all kinds of computer simulations.  The economists are doing what they always do, carefully crafting their words to make sure they are right about any future event.  While our job as individual investors or investment advisors is not as intellectually challenging, we don’t have the luxury of posturing.  Our job is a front line job and where the rubber meets the road.  Our job is to synthesize and act and in order to do this we must have a framework.  If you are a do-it-yourself investor, you should have one yourself.

So what does the rise in rates mean to us?  Because our approach to investing is not reactive but mindful, to us it simply means, the Federal Reserve raised interest rates for the first time in close to a decade.  In other words to us the event means---who cares?  It is just another event, another data point.  It is as important to what we should buy or sell as what ESPN has to say about what team is doing this or doing that.  What matters is having a technique in place that tells us what we are going to do about it.  It needs to tell us what to do, and when to do it.  You should have a system in place to do this or you should read about the ways we and others do it and develop your own.

Here’s today’s reality from our perspective and why a diversified portfolio of stocks, bonds and cash is going to be a losers game for quite some time.  The median price of a US stock is more expensive today than at any time in the last 100 years.  While this may have no bearing on what happens in the near term, you can be certain that stocks will sustain a drop down in the not too distant future.  What are you going to do about it when this happens?  More importantly, what are you going to do for your particular set of circumstances?  Here’s what else we know.  Bonds have had a great run for over 30 years and pay very little today.  Guess what, with a 10-year US Government bond yield of 2.25 percent what you can expect to earn in an investment such as this over the next 10 years is------drum-roll please----2.25 percent.  What else do we know?  Money market funds or cash is paying rates near 0 percent.

This is A What to Do Today Tale for a reason.  You must be cognizant of the market environment.  While markets spend most of their time in periods where stocks can provide attractive returns, there are periods where they are extremely cheap or extremely expensive.  A wise investor incorporates these extremes into their investment approach.  In October 2008, they were extremely cheap and today they are extremely expensive.  While we learned in A Tale of Today that today is every day, the lesson of that tale is that you must have a plan and a strategy to navigate every type of environment and it must be one that either you or your advisor can execute.  I seriously doubt that people are prepared, much less their advisors for what I see happening over the next 10 years.  If you have a diversified portfolio of stocks, bonds and cash, which you rebalance periodically, you are going to be sorely disappointed.  If you are paying your advisor, 1 percent-2 percent per year for them to “invest” your money in this simplistic and commoditized fashion, I suspect you will be paying them all your profits in fees.  Furthermore, expect to make nothing and while making nothing, expect to have a very volatile ride along the way.  With stocks expected to earn no more than 2 percent over the next decade and bonds slightly more and cash close to zero, most or all your profits will be going to your advisor to pay their fees.  This is not a pleasant forecast. 

So what can you do to overcome this hostile investment climate, where classical simplistic diversification isn’t likely to work and is not going to provide anywhere near the rates enjoyed historically?  What are you going to do if you need your portfolio to provide you with income for life and at a rate in excess of 4 percent-5 percent per year?  How are you going to maintain your standard of living?  What about our nation’s pension plans that need at least a 7 percent return in order to continue to pay and meet future retiree obligations?  This is the question every investor is asking and if they aren’t they should.  On the surface, there appears to be a limitless number of potential successful strategies.  However, when you peer underneath the veneer, they all share one of three things.  They must all make concentrated bets, rely on successful trading techniques or employ some level of hedging. Read A Tale of Identity for a detailed explanation.  With the future of diversification in doubt over the near term, you better be equipped to concentrate your portfolio and be right about your bet, trade successfully or hedge.  The diversification gravy train is currently under repair.

In closing this tale, always remember there are only four types of people; those accumulating wealth that aren’t wealthy yet, those that are accumulating wealth and might be wealthy, those that are distributing wealth and are wealthy and for the unfortunate souls, those that are distributing wealth and aren’t wealthy.  As our readers know, we are strong advocates of aggressive investing for those that are accumulating wealth and aren’t wealthy yet.  You can read why in our white paper entitled, The Trampoline Effect, and you can read a case study in A Disciplinary TaleIf you fall into this category and are one of our followers, you don’t practice diversification in the first place and this tale has very little meaning.  However, if you are one of the other three types, pay attention.  The future of classical diversification will more than likely not solve your situation.  This tale is a wake-up call and a market call. 

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Topics: FINANCIAL TALE, Stock market, Volatile Tales

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