The career of one of the most accomplished players in sports history appears to be coming to a notorious end. On Monday, Alex Rodriguez of the New York Yankees was suspended by Major League Baseball through the end of the 2014 season for violating the league's performance-enhancing drug (PED) policy. This latest sports scandal has essentially wiped away an extraordinary career that spanned twenty seasons in which he became the youngest player to reach the 500 and 600 home run marks. Of course, Alex Rodriguez is just the latest in a long line of athletes in recent years to experience such a dramatic fall from grace for using PEDs. It also provides an important lesson that reaches well beyond sports and includes investment markets. For while accumulating impressive statistics and setting new records may result in great personal wealth and cheering crowds, accomplishing these results through the use of artificial stimulants and performance enhancements almost always leads to a very bad ending.
Investment markets have certainly benefited from performance enhancing monetary stimulants over the last several years. And nowhere has the impact been more pronounced than in the U.S. stock market. From the moment that the U.S. Federal Reserve began injecting stimulus into the bloodstream of financial market through daily U.S. Treasury purchases in mid-March 2009, the stock market has generated unprecedented results. This has included a +180% total return on the S&P 500 Index (SPY) since the market bottom in March 2009. Stocks have also generated positive returns on 56.3% of all trading days over this time same period, which is nearly +3 standard deviations above the historical average. In other words, the stock market's current daily winning percentage ranks in the top 0.4% throughout market history. And all of this has been accomplished amid lackluster global economic growth in the immediate aftermath of a major financial crisis that nearly collapsed the global financial system. It has been truly remarkable performance by stocks to say the least.
Many pundits claim that the stock market rally has played its part in rescuing the global financial system. Indeed, conditions are much better today than they were during the darkest days of the crisis back in October 2008. The U.S. Federal Reserve should be commended for taking swift action at the time by launching QE1, as allowing the financial system to collapse would have resulted in a far worse outcome. Once the global economy was pulled back from the brink, however, the decision to engage in QE2, Operation Twist and QE3 has been far more dubious. Looking ahead, we will likely not know the cost associated with these repeated stimulus programs for years to come, but it represents a considerable risk for financial markets going forward.
Of course, it was not long ago when another type of rescue was occurring in the sports world. In 1994, Major League Baseball was in crisis following a labor dispute that cancelled both the season and the World Series that year. Although the labor strife was settled and play resumed for the 1995 season, many disenchanted fans decided not to come back. But after several years of sagging attendance, baseball was revitalized in 1998 when Mark McGwire of the St. Louis Cardinals and Sammy Sosa of the Chicago Cubs engaged in a race to break Roger Maris's single season home run record of 61 set in 1961. This, of course, was a record that exceeded by only one home run the previous record of 60 set by Babe Ruth in 1927. Fans rushed back to the game to watch the pursuit of the home run record throughout the 1998 campaign, and McGwire and Sosa were being hailed for saving baseball as a result. By the end of the season, Mark McGwire had hit 70 home runs while Sammy Sosa finished with 66. How did these two players manage to rescue baseball and break a home run record that had stood for decades by 8% to 15%? The answer is now clear that performance enhancing drugs played a big part in their success, but the only thing that seemingly mattered at the time was that baseball had been saved.
Unfortunately, baseball continues to suffer the fallout effects from this reliance on players using performance enhancing drugs to revitalize the game. More than a decade later, the use of performance enhancing drug remains endemic not only in baseball but in a variety of other sports, with Alex Rodriguez serving as only the latest example of the problem. This has caused many fans to increasingly question the integrity of many sports and the players who participate. As for the careers of McGwire, Sosa and the many other recent record breakers including Barry Bonds and Roger Clemens, they are all now remembered with contempt instead of celebration.
A similar dilemma is building for investment markets today. For the endless flow of monetary stimulus from global central banks that was once heralded for saving the global financial system a few years ago is now breeding mistrust among investors and fostering potentially serious problems for markets to navigate going forward.
First, the traditional relationships that have long defined investment markets have been distorted beyond recognition. It was not long ago that investors could make reliable investment decisions based on the application of fundamental and technical analysis. They could also depend on various statistical relationships such as correlation and mean regression to hold over reasonable periods of time. But many of these functions are increasingly breaking down and selected statistical measures remain at historically wide deviations from the norm. This has compromised the ability of investors to construct and maintain an investment strategy without encountering extreme volatility and potentially sizeable losses at any moment in time.
These distortions have had negative implications for leading money managers in the current environment. For the last five years, a vast majority of hedge funds have underperformed the stock market as measured by the S&P 500 Index. To be certain, the hedge fund industry has its share of charlatans. But it also boasts scores of highly accomplished individuals that have proven the ability to add considerable value over time. Have most of these hedge fund managers suddenly become stupid over the last five years? Or is it more that the various interrelationships that had long defined investment markets have been inextricably changed by the unprecedented actions taken by global policy makers over the last several years? When unpredictable market swings are occurring as a result of Fed speeches and guesses on how an economic data point might influence the direction of future monetary policy, this represents a market environment defined more by randomness than anything driven by traditional fundamental and technical analysis. One has to look no further than the wild swings in the stock, bond and commodities market surrounding last Friday's employment report to find evidence of such extreme market reactivity and lack of discipline.
Conservative investors are being particularly impacted by persistently aggressive monetary policy. It was not long ago that those living on a fixed income including retirees could build a portfolio that would safely meet a 4% drawdown requirement. Today, this is an exercise fraught with meaningful downside risk. Gone are the days when conservative investors could use a ladder of FDIC insured CDs complemented by income generating bonds and high quality stocks to achieve reliable growth above and beyond their drawdown rate. Instead, conservative investors are now forced to reach for yield in relatively higher risk areas such as long-term U.S. Treasuries (TLT), high yield bonds (HYG), REITs (VNQ), emerging market debt (EMB) and dividend paying stocks (DVY) among other categories. As a result, their principal is now at risk of considerable downside loss in trying to reach a level of income that still pales in comparison to what they would have been able to more safely achieve in a normal interest rate environment. With millions of Baby Boomers now entering retirement, this issue represents a mounting challenge to a growing number of investors with each passing year.
But perhaps more significantly than anything else, the psychological damage caused by monetary PEDs may exceed any physical damage in the end. Many professional and individual investors do not make investment decisions at random. Instead, they build portfolios and implement strategies through historical research, rigorous analysis and meticulous execution. But when their carefully constructed investment strategies are overrun by the impact of monetary doping and the resulting market randomness, investors are not only deprived of the ability to achieve their goals but also the confidence in their decision making. In short, the continuous injection of monetary stimulus into markets is effectively stealing away what was once a dependable source of long-term savings for so many. And when professionals and individuals that have devoted many years to building successful investment strategies lose confidence either in their own abilities or the integrity of the markets, they do not abandon their strategy and rotate into stocks as some have recently suggested. Instead, they move to cash and walk away from markets altogether. This is a major long-term risk facing investment markets today.
For the many professionals and individuals that remain committed to investment markets, they should resist the temptation to simply chase performance in the stock market. Instead, they should stay dedicated to an investment philosophy that they believe in while also keeping in mind that the market's dependence on performance enhancing stimulants has the potential to end badly. This does not mean that investors should completely forego an allocation to stocks or any other asset class that offers attractive opportunities, just as clean baseball players should not quit the game just because other players are using PEDs. Instead, investors should stick to their long-term beliefs while adjusting their models accordingly to adapt to the current market environment while also clearly recognizing the potential risks associated with their allocations. Such adjustments may include a sizeable allocation to cash for an extend period or avoiding selected categories that had once proven reliable in a more normal market environment.
In this regard, I remain allocated to U.S. stocks across both large caps (VOO) and small caps (IJR) with an emphasis on industrials (XLI) and financials (XLF). But this stock allocation represents a relatively small percentage of my overall portfolio strategy, as a majority of my portfolio strategy is currently in cash awaiting better entry points not only in stocks but across a variety of asset classes including bonds (BND) and commodities (DJP).
The day will eventually come, and it may arrive soon, where global central bankers begin slowly eradicating performance enhancing monetary stimulus from investment markets. And those investors that stick to their long-term discipline and are prepared in advance for such a shift have the potential to reap great rewards in the end.
Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.