A few days ago, I wrote an article about Bain & Co.'s predictions for global financial resources. (In that article, I erroneously identified Bain as a "private equity" firm. The firm kindly wrote to correct my description. Bain is a "global business consulting firm".) Bain & Co., I said, has come out with a fascinating set of projections for the global capital markets. "The specific numbers are interesting, but few of us can know exactly what they mean. We can understand the generality of Bain's report: The world is awash in money looking for someplace to invest that will earn a return, and over the rest of this decade, the amount of money looking to be invested will grow by about 50%. What does that imply?"
I suggested that it implied several things:
- Low short-term interest rates that we now attribute to central bank activities may remain low, even if and when the central banks stop buying securities and raise the basic rates at which banks can borrow from them.
- If short-term interest rates remain low, where is capital going to go to earn income? It must go up the risk curve because although capital can sit idle, earning little for a while, it cannot do so for the long term.
- If capital must go up the risk curve, it must invest in junk bonds and equity, as well as fancier strategies that seek to take advantage of small arbitrage opportunities. Junk bonds will, therefore, suffer losses from time to time, and the arbitrage opportunities will be competed away by the smart people managing the money looking for the opportunities. That will leave equity as the most likely place for decent returns. But those returns also will be competed away as world markets get frothier, simply because there is nowhere else for the money to go. That will lead to another crash when interest rates turn back up, probably as a result of a spike in inflation, or due to some other unsettling event.
At the end of the article, I said I would write a follow-up explaining how I would attempt to configure my portfolio to comport with the financial world that I would expect based on Bain's predictions.
Bubbles, Bulls and Buffetts
The world of financial commentary moves apace. On February 7, 2013 Federal reserve Board Governor Jeremy Stein had warned of the possibility of a bubble in junk bonds. Some of us had worried about that for some months. But the day after I published the article on Bain, the Financial Times scooped us all by telling us that the smart money already had been making hay by shorting the junk bond market and that-a sure sign that we are not ahead of the curve-retail investors have been switching out of junk bond funds since the beginning of the year.
All that is great news because maybe bubbles will tend to prick themselves early for a few years, while the memory the last big bubble is fresh.
At the same time, Arne Aslin published an excellent bullish article on SA in which he predicted a further decade of excellent returns for stocks. His logic makes sense and I recommend the article highly, although I am not as convinced as he is regarding the bullish case.
However, on the same day that the FT wrote about junk bonds, Cullen Roche pointed out on SA that Warren Buffett's favorite index was signaling an overbought market. Here is the graph of the Wiltshire 5000 stock index against U.S. GDP that Cullen published as part of his article. Cullen Roche is a fine economist. But at the same time, Buffett was signaling confidence in the future by buying Heinz.
In a recent article on SA, Doug Short also warned that the market is overpriced. Here is one of his illustrative graphs:
Doug Short is a great economic analyst.
I assume that at any time there will be smart people disagreeing about the market's direction. Otherwise the market would go where all the smart people said it should go. And the market can remain over or under priced for long periods of time. (The market can stay irrational longer than you can stay solvent, in Keynes's famous phrase.) In addition, factors such as low interest rates can influence the pricing of the market relative to historical norms. I think we may well be in such a period now, as reflected by the market having been relatively overpriced since 2010 by many historical measures. And we may remain in such a period as long as interest rates remain historically low.
Goals for the Portfolio
My basic thesis is that if Bain is correct about the amount of capital that will be floating around in the markets, I think a seriously overbought stock market is likely in the next few years. I also think that the market is likely to come down precipitously at some point during that time period due to some unanticipated event.
I am not certain that Bain is right. But I do think that some variation of its prediction will be correct. Therefore I should fulfill my promise to suggest a strategy that takes it into account.
The task is to design an investment program that
(1) takes advantage of the possible-I think probable-continued superiority of equity market returns over the medium term,
(2) protects against inflation (even though I do not think inflation is likely in the medium term, it should be part of an investor's planning) and
(3) assumes there will be an unsettling market event some time in the next five years.
The first basic decision is asset allocation. I am not a gold investor, so I will leave out gold. You can allocate to gold, if that is your fashion.
I do think some allocation to real estate is still good at this stage of the real estate cycle, and a substantial part of the world's excess liquidity is likely to go into real estate, thereby causing an upward trend in prices. But I will not include that because I think the type of real estate allocation depends very much on one's capabilities. What I mean by that, by way of example, is that a friend of mine owns about a hundred small homes that he rents out; he sells them when the opportunity presents itself. It is a very nice business. But it is a lot of work, and even if you hire craftspeople to do the work, you have to have some expertise in upkeep and the business of evaluating tenants and pricing. I thought that maybe I would invest some money and buy a few similar houses. My friend offered to teach me the business. What I realized, however, was that unless one were going to own, say, ten houses, the business was very labor intensive and potentially volatile. It was not for me, I decided.
Real estate tends to be like that. It is a great business if you are hands on. Having some scale makes it even better. Investing from afar, it is like stock investments-just another sector. I still like iShares Dow Jones US Home Construction Index Fund (ITB), which I recommended about a year ago and is up about 50% since then. Some commentators complained that the smart money already had made money on ITB and that I was too late. In that case, I was right that there was still time. Whether there still is much growth left, I am not sure. But I am not selling, and I think some exposure to the housing industry is a prudent part of a current portfolio, even though usually it is quite leveraged and is likely to be volatile, based on history.
For many investors, less leveraged suppliers to the real estate industry and to new households would be better choices for exposure to this sector.
My own current allocation is about 50% in equities. I am inclined to adhere to that, more or less-buying when I think there is a good opportunity, selling when I think a stock is too far ahead of itself.
I do not much like fixed rate bonds at this time. Too little upside for too much risk. But I think an allocation to bonds that protect against inflation makes sense. Such bonds include TIPs and variable rate bank loan funds. They provide additional income without significant inflation risk. I use the Schwab TIPs fund (SWRSX) because Schwab is my broker, but other such funds probably are just as good, as long as they have no load, no 12b-1 fee, and a reasonable expense ratio. Most of the major no-load fund families have suitable products.
If you want to be more hands-on, you might take a look at peer-to-peer lending through, for example, Lendingclub.com. I have a very small portfolio there that I have been experimenting with. My return over the first year and a half or so has been close to 10%. But I would not expect good returns without doing work to select the risks you want to take. The key is to take some risk but to keep losses to a minimum.
In the aggregate, a 20% allocation to income securities that do not have significant interest rate risk makes sense to me.
Cash is absurd, but it is the default category. It stays at about 30%, subject to opportunities.
Many investors would use various option strategies to achieve the ends that I am trying to achieve. Buying out of the money puts on broad indexes while remaining more fully invested in equities, for example, might be a sensible alternative. I confess that I do not have sufficient experience investing in options to have confidence that I could use them accurately.
The Equity Portfolio
In equities, I am paying more attention than ever to sound balance sheets. If and when the market event occurs, companies with good balance sheets will fare better than highly leveraged companies. I own stocks of a number of companies that have little or no debt and large amounts of cash.
I was delighted to see Berkshire Hathaway (BRK.A) using some of its cash to buy a great company like Heinz this week. I think Berkshire is an excellent part of the kind of portfolio that can take advantage of the likely medium-term opportunities while providing relative protection on the downside. (Yes, there is no dividend. But as Mr. Buffett points out, probably he has a better long-term investment record than you do.)
I was happy with Cisco's (CSCO) earnings, I was not upset by Apple's (AAPL) last report, I certainly would be in oil stocks, since oil is an inflation hedge and there are many oil companies that are not highly leveraged. I am not sure I want to be heavily into the refiners at the moment because they have done so well. (I am having a hard time deciding whether to sell some Marathon Petroleum (MPC), Valero (VLO) or Phillips 66 (PSX). The industry still appears to be well positioned, after several hard years. But the run-up suggests prices may be high, and refining always has been cyclical.)
I like the healthcare sector because it is less affected by economic events than many others. However, many healthcare companies are at risk because they may not keep up with technology or may be victims of changing laws and regulations. Two companies that I like that have grown consistently and have little or no debt and no appreciable goodwill on their balance sheets are Bioreference Laboratories (BRLI) and Healthcare Services Corporation (HCSG). Neither is large (they compete with larger companies), but both are leaders in their fields that have significant continued growth prospects.
I am trying to stay away from heavily indebted companies that, although they may perform very well for a period of time, may be vulnerable to extreme downsides. In that regard, when you read a balance sheet, I suggest that you pay less attention to cash and to the traditional quick ratio than to the amount of tangible equity the company has. Maybe I have been looking at bank balance sheets too long, but tangible equity seems to me like the most important balance sheet number if there is a market event. If the tangible equity is high, the company can ride out rough patches, even if long-term debt needs to be refunded or short-term debt becomes more expensive. Goodwill is not a tangible asset, and the financial world is likely to look askance at it when things are bad.
Timing the Market Event
To recapitulate: About 50% to equities, 30% to cash to take advantage of opportunities and for a rainy day. Berkshire, Apple and Cisco seem to me like parts of a core portfolio. I have not included any banks because I worry about them in a market event. Oil is a must, it seems to me. So is some healthcare. And be diversified but not diworsified. If you have too few good stocks you want to own, diversify through mutual funds.
I would not bet that I could anticipate the next market event. I anticipated the last one but did not anticipate its depth. Nor did I have the courage to sell more than a quarter of my portfolio all at once. I had called the top twice (in May, then October 2007), but did not have enough courage to sell enough, and I bought back in too soon. I do not expect to call the next top, and if I did, I do not expect that I will have more courage than last time. Therefore I will try to protect myself structurally so that when I fail to be prescient, I will not suffer too much, but still will have an opportunity to benefit from what I perceive are likely to be some continued pretty good times in the market when compared with what I can earn elsewhere.