Time to Cautiously Get Back in the Game

It’s no secret that risk premia have taken wing in recent months, as our chart below illustrates. Nor is it any mystery as to the cause. Prices have slumped like a rock in a lake, and that’s boosted trailing yields and interest rates to the sky. What’s less obvious is if it’s time to avail oneself of the relatively rich offerings.

Alas, the answer to this perennial question is always debatable. Even in the best of times, the wisdom of investment decisions is always in doubt, albeit in varying degrees depending on the context du jour. But this is a major hazard only if you’re betting the farm on a given day or limiting your investment world to a narrowly defined subset of assets. Avoiding those dangers are essential for sound investing and sound sleeping, although it doesn’t allow us to completely sidestep uncomfortable choices or mistakes. Nonetheless, it’s a sound basis for putting our investing strategies on a sound foundation for improving the odds of long-term success.

On that note, your editor is of a mind to begin indulging. In fact, we’ve been suggesting that in recent months and the advice stands anew. Not because we have a crystal ball. Indeed, the capital markets still face tough times, perhaps for an extended period. Looking back a year from now will dispense exactly the right strategy, although that and 50 cents will buy you half a pack of gum in the here and now.

The task of taking advantage of higher prospective returns must begin at some point. Waiting for the “all clear” bell looks great on paper, but in the real world market bottoms and tops are identified only in hindsight. By that time, a fair amount, perhaps most of the rebound is behind us. Yes, there’s always a good case for waiting, but there’s a risk in times like these that the waiting becomes habit. Patience is a virtue, but even virtuous behavior has limits.

Capital Spectator is an advocate of multi-asset class portfolios and adjusting portfolio allocations over time by taking cues from current conditions and reasoned projections of the economic and financial climate. In other words, we’re fans of holding a mix of stocks, bonds, commodities, REITs and cash and adjusting the mix based on current and expected conditions.

We don’t take this view lightly. Rather, ours is a perspective born after years of reading the financial literature, interviewing some of the world’s best strategists, crunching the numbers and analyzing real world results. In an effort to consolidate and categorize what this reporter has learned, we’re currently writing a book on the subject and will soon launch a newsletter dedicated to the topic (details to following in coming days and weeks). But for this post, the point is simply that winning the investment game requires action. Reasoned, well-timed, informed action, to be sure; but action just the same.

It’s tempting to think that we can put off crucial investment decisions until the buy and sell signals flash with unmistakable clarity. But the transparency arrives only in the rearview mirror, once we’ve sped past the opportunistic junction. In real time, the challenge of investing is working with an unknown future and wondering if our analysis today will prove worthy tomorrow.

There are several defensive tactics to employ to limit the associated risks without giving up too much of the prospective return. One is refraining from making bold changes to asset allocation in a short time period. Alternatively, one can and should practice an ongoing rebalancing/tactical asset allocation program. In addition, we should emphasize changing portfolios at times when conditions appear to favor our odds of enhancing future returns.

By that standard, 2008 has become an increasingly opportunistic year in terms of higher expected returns. That’s not to say that the trend won’t continue; if fact, we expect as much and so we must pace ourselves in terms of shifting assets into asset classes with better prospects while reducing allocations in those areas with declining expected returns.

Perhaps the crucial point is that dynamic asset allocation is a process rather than a one-time event. Time diversification, in sum, is crucial for strategic-minded investing. We can’t see peaks and troughs in markets in advance and so we should embrace apparent opportunities modestly, over time.

In essence, this is all about finding the optimal approach for exploiting the time-honored notion of buying low and selling high. As we discussed in 2006-2008, the extraordinary gains in everything was a signal to begin winding down risk exposures, albeit modestly, systematically and over time. We now encourage the flip side of that counsel.

Yes, we were early in recommending lowering risk levels in 2006-2008, and we’re likely to be early now in proposing that strategic-minded investors begin elevating their risk exposures. That’s the nature of contrarian-based investing, arguably the only prudent approach for long-run investment strategies.

No one said it would be easy; in fact, it’s downright awkward at times — like right now. So it goes in a world where mere mortals are faced with making imperfect decisions using limited information. As Winston Churchill might have said if he was an investment strategist in 2008: It’s the worst investment strategy available, except when compared to everything else.

Comments

[herbert hoover:]

LOL

2008 Dec 15 04:01 PM

[jepittman:]

Excellent rebuttal HH. You do yourself proud.


On Dec 15 04:01 PM Herbert Hoover wrote:

> LOL

2008 Dec 15 04:15 PM

[User 320161:]

But who's gonna lend me the money to buy more stuff that I don't need? I mean... I just lost my job, and my ARM is gonna reset, and a box of cereal cost $4.

2008 Dec 15 05:02 PM

[Hutch:]

The comment, ."As Winston Churchill might have said"
reminded me of an essay by David Friedman
www.daviddfriedman.com...
The Treasury and Fed have yet to find a way to budge this paradox.

2008 Dec 15 06:06 PM

[CautiousInv...:]

Bold moves are precisiely what is required if one is to avail himself of the opportunities at hand. Minor portfolio adjustments in the midst of this tsunami is a prescription for continued losses. Gold, hard commodities and high grade commercial paper in the near term. Longer- term, It's shaping up to be a battle between the analysts/technicians ( Meredith Whitney, Louise Yamada, Whitney Tilson and Credit Suisee ) versus several legenday investors ( Warren Buffet, Bill Miller and others ). Unless history reverses itself, the housing sector must improve before the recession can end; the last test of the market trough will occur approximately three months before the recession ends. So, to make a case for investing you must believe the housing market will recover within the next three months, which appears most unlikely in view of the belief that foreclosures will continue well into 2012 and that the second wave of foreclosures will be driven by Alt A and Option ARM instruments. Add to this that the consumer, who accounts for 70% of our $ 14 trillion economy, must retrench and delever as a result of credit curtailment, it becomes increasingly difficult to believe there will be any market recovery of significant proportions. And the impact of the promised economic recovery act, is several years away. Thus while stocks are cheap or under valued by some metrics, they are likely to cheaper.

2008 Dec 15 06:30 PM

[BxCapricorn:]

Translated: Bernie Madoff, Investment Banks, and the rest of the "Financial Elite" stole everyone's money, but trust us! Get back in the game! Please move your retirement money back into equities, the coast is clear. This is the 14th bottom call, and that's always the charm.

Didn't work?

"Get that clown Cramer back in make-up, cue lunatic rant.... three....two....one (silent)..."

"Hey this is Cramer...some people want to make friends.....I just want to make YOU money...."

2008 Dec 15 06:52 PM

[Anthony Alfidi:]

Risk premia are important, but the underlying health of an asset class is even more so. High yield bonds are the first to default in a downturn, and investment-grade corporate offerings are being massively downgraded to the point where the high yield field is getting crowded. As for REITs, commercial mortgages are just beginning to go bust.

Nothing wrong with sliver-thin allocations to underappreciated asset classes. Just consider the macro picture that contributes to earnings quality.

2008 Dec 15 08:09 PM

[bosun.j:]

Is this guy trying for the Madoff wanna be of the year award?

Time to get back in my sticky rice!

2008 Dec 15 08:28 PM

[Jackson Cash:]

Translation: Time to get your ass kicked, one eye-poke at a time.

2008 Dec 15 08:59 PM

[sheople:]

Aw c'mon guys. I don't want to be the only one to get sheared.

2008 Dec 15 10:37 PM

[bobomite:]

Nice collection of anecdotes. Was there a point?

2008 Dec 15 10:42 PM

[OnMargin:]

A constructive post. Many prominent bears and value investors are preaching something similar. Easy to sell fear and darkness - much more difficult and insightful to be constructive. That being said, the market is significantly off its low - caution might be warranted in the short-term.

2008 Dec 15 11:01 PM

[jepittman:]

IMO there is nothing that validates the points made by the author like derision. It is out of such as this that new bull markets are born.

2008 Dec 16 12:14 AM

[gabe borens...:]

In fact this is a great opportunity for the investors.
All of the structural weaknesses are being addressed with a capital infusion. Some additional time may be required for restructuring of some sectors. Few business models may have to be modified.In the end it appears that some trillion dollars of capital wll be provided to the broad economic sectors.Allowing for the multiplier of seven ,that is about seven trillion dollars of stimulus or about 55% of the GDP-unheard of catalyst/jolt.
While explosive unemployment is unnerving ,it is a lagging indicator.
By the 1st qtr of 2009 economy will be stabilized and by the 2nd qtr it will expand moderately .
By the second half of 2009 we will see a major economic rebound.
In the meantime any sector under the stress should be assisted "financially".
The SEC should impose moratorium on the short positions for a year enhancing the impact of the liquidity injection.

2008 Dec 16 01:04 AM

[Robert Nabloid:]

There are definitely some bargains out there for those really looking. That said, the fundamentals still look shaky. There is still plenty of downside risk. The layoffs have just begun. Caution is advised.

2008 Dec 16 01:53 AM