In Investing, As In Life, It's All Relative

by: Invest With An Edge
Summary

Investing is about more than asset classes; it's about time.

In creating a portfolio, it is just as important to reflect multiple frames of reference.

Diversifying by strategies can accomplish the same thing, but with a bonus of adding dynamic risk management to the picture.

By Jerry Wagner

I was at physical therapy for a back ailment the other day. They had me begin on the treadmill. Trudging along, time seemed to drag. Reaching the end of the exercise interval seemed like a distant goal. As I looked around the room in abject boredom, I noticed a group of therapists chatting away with another client. They were animated. The level of chatter increased. They were so engaged!

When the bell rang, indicating that my drudgery had finished, one of the therapists came running over. She exclaimed, "Oh, that was fast. It seems like you just started!"

This experience reminded me of Albert Einstein's explanation to his theory of relativity: "When you are courting a nice girl, an hour seems like a second. When you sit on a red-hot cinder, a second seems like an hour. That's relativity."

Einstein's special theory of relativity posits that time slows down depending on your frame of reference. He recounted how time to one on a moving train moves slower than time for a loved one waiting at the station. Today, countless movies have been based on how aging slows for those on a moving spacecraft relative to those left behind on earth.

Everything is relative. This same concept of how what one experiences depends upon their frame of reference can help investors understand what's happening in the financial markets.

For example, when one asks how the stock market is doing, the answer depends on the time period referenced.

A five-day view of the S&P 500 can look this bleak:

While a longer-term view can convey a different message:

In building strategies, my firm tries to take this into account by measuring what the market is doing over multiple time periods. We do this to obtain a different perspective by changing our frame of reference. In the long run, we believe that this makes a strategy more robust in dealing with the future.

Investing is about more than asset classes; it's about time

Another method is to create strategies designed to perform in different time periods. One strategy may be created to capture short-term moves in stock prices, while another may focus on an intermediate-term period.

In creating a portfolio, it is just as important to reflect multiple frames of reference. We can do this by using multiple strategies that each focus on different time periods. Of course, this is what we do when we use different assets to diversify a portfolio (see the following graph). Just looking at the action in stocks (dark blue), bonds (light blue), and gold (purple) over the last five days can demonstrate the effectiveness of this. Stocks tumbled while bonds and gold soared.

Diversifying by strategies can accomplish the same thing, but with a bonus of adding dynamic risk management to the picture. Yes, last week our stock strategies generally tumbled, to a greater or lesser degree based on their suitability profile and exposure to equities. But our bond and gold portfolios prospered.

When you look at the markets over a longer time, it is also clear that a longer frame of reference reinforces the view that all three assets should be included within a core portfolio. In creating such a portfolio, it is important to have assets that have (1) positive returns over the long run and (2) a life of their own. In other words, they don't always move in sync with one another.

We offer core portfolio strategies formulated around these concepts. Performance is monitored and evaluated over multiple time periods within each. And each uses all three asset classes in the manner necessary to meet our two prerequisites for a core portfolio.

Of course, this is all consistent with a portfolio that is constructed using modern portfolio theory. The difference is that each of these core portfolios also includes dynamic risk-management tools designed to help defend against the ravages of super bear markets (markets that lose 20% or more).

Diversification certainly helps when the market goes through a correction, a sideways market, or a baby bear market (markets that decline less than 20%). But to avoid the worst of a major bear market decline, dynamic risk-management tools like hedging and moving to the safety of defensive holdings are essential.

A different way of evaluating your portfolio's success

Evaluating the success of the resulting portfolio requires an understanding of relativity as well. Strategies should be evaluated not alone but rather relative to the performance of the other strategies in the portfolio.

When big events happen in the market, if all of the strategies in your portfolio move in the same direction, your portfolio is not diversified. You may not think this is a problem when your strategies are all moving up together; however, if this is what is happening in your portfolio, I can almost assure you, you will also see them all fall together at some time in the future.

Similarly, portfolios should be evaluated from different points of reference. Make sure to evaluate the portfolio as a whole, not just on a strategy-by-strategy basis. And make it truly relative by asking, "How is it performing relative to the risk being taken?"

Performance shouldn't be judged in a vacuum or compared to an equity benchmark that is not relevant to the risk you are willing to take. Rather, it should be gauged by comparing it to like investments that are unmanaged (a 60/40 fund portfolio, for instance, if you are in a balanced suitability profile) and also to a customized benchmark based on your initial goals.

Similarly, portfolios should not be evaluated over a single fixed period. Instead of looking at the results over a single bad week or a short, choppy period, take a step back and see if the portfolio did what you expected it to do during positive periods. This year, how did it do when stocks rallied during the first four months of the year? How did it do in June and July when new highs were being made?

If it participated reasonably (relative to like investments) during these periods and mitigated some of the losses in the fourth quarter last year, it probably should not be abandoned. This is so even if all of the strategies in your portfolio did not perform equally well.

Investment performance, like most experiences in life, is relative. The key to successful investing is being able to answer the question "Relative to what?" Hopefully, this discussion gives us all the same necessary frame of reference to answer that question.

Market update

The major stock market indexes all finished down last week. The Dow Jones Industrial Average lost 2.60%, the S&P 500 Stock Index fell 3.10%, the NASDAQ Composite fell 3.92%, and the Russell 2000 small-capitalization index lost 2.87%.

The stock indexes were down every day last week, just a few days after hitting new all-time highs on July 26. While this proved to be the worst week of the year, Monday of this week (8/5) was the worst day of the year, as all of the stock indexes plunged further. Continuing their run as safe-haven assets, gold and bonds gained ground in the face of both last week's and Monday's stock market decline.

The stock market faced double trouble last week. First, the Federal Reserve disappointed the bond markets with a quarter-point cut instead of the hoped-for half-point cut. Then, on Friday (8/2), President Trump announced the possibility of more tariffs on China. China retaliated by halting U.S. agricultural purchases and devaluing the yuan substantially.

Let's look at the Federal Reserve action first. The Fed once again lived up to its reputation of being behind the curve. Its actions were probably too little, too late as a number of indicators are now suggesting that a recession is on its way or may have already started.

At the very least, we are in a slowdown. Of the 38 economic reports published last week, 20 fell short of hitting economist targets, 11 did better, and seven met expectations. Major disappointments were in personal spending and income.

Friday, the ISM Manufacturing Index also disappointed, and that was matched by the ISM Services (non-manufacturing) report on Monday. While both are still above the 50% demarcation, indicating that the economy is still growing, they have hit a three-year low.

There were some good signs in the economy and the level of interest rates. The same reports indicated that the rate of inflation is likely to tumble, giving the Fed room to continue lowering rates. And consumer confidence, again, was up.

In addition, it seems to have gone unnoticed that the Fed also stopped its quantitative tightening program of failing to roll over its inventory and selling Treasurys. This was not to have occurred until September. Some have estimated that this could be as positive as another quarter-point rate reduction.

Furthermore, as I said, the Fed is behind the curve again. The bond market has effectively been lowering interest rates for months. And following this last failure of the Fed to act more decisively, the markets stepped in and dropped rates further. The probability reflected in the futures markets of a September rate cut by the Fed has now soared to 100%.

Not only could this spur the economy (especially when compared to the huge fiscal stimulus in the budget deal), but it places yields across the yield spectrum at a very unfavorable level in relation to stocks. This makes stocks more attractive than bonds simply on a yield basis.

Turning to the tariff issue, every time this thorny matter is mentioned by the White House, investors have panicked. It started the fourth-quarter correction last year and the May decline this year, and here we go again.

Obviously, when the two largest economies are in a virtual cold war on the trade front, investors are going to be nervous. Yet, when one examines the facts, it seems that the U.S. has the better position and the economic effects are going to be minimal.

Republicans and Democrats quarrel over who pays the tariffs: the Chinese or the American consumer. According to William Lee, Milken Institute chief economist, the data currently supports only the fact that the importers have to pay the tax, but so far, they have not passed much of it on to consumers. Objective parties outside the U.S. have said that 70% has not been passed on but is borne by the Chinese.

Furthermore, the Chinese retaliation by devaluing the yuan makes their goods cheaper to U.S. consumers. The effect of this is to negate not only the existing tariffs but also those threatened for September.

I believe that in the long run this will hurt the Chinese in their ongoing efforts to establish the yuan as an international substitute for the U.S. dollar. Devaluation is a weapon used by counties more concerned about specific internal issues rather than being a global standard.

Like the last three times the tariff issue spooked the markets, I believe that the market will bounce back when cooler heads prevail.

As of Monday's close, the S&P 500 had fallen over 6% since its new high on July 28. This is the second 5%-plus decline this year. The average number of 5% declines in a year is three. Last year, though, we had five. The average loss after a 5% decline is 8.36% and lasts 23 days.

Volatility has certainly increased since the Fed's decision, and the current decline has been especially swift. Usually when this happens, we bounce back.

Still, investors have to realize that we are in a massive consolidation period. With five corrections of 5% or greater last year and two this year, despite the new highs, the stock market has not been growing since January 2018.

This consolidation could easily continue. The uncertainty bred from news about interest rates, recession, tariffs, and the lead up to the 2020 election will continue to hang over the markets.

We could break down into a "super bear" (a market decline of 20% or more). Or, the stock market could do what it has done the last six time that the market corrected: It could break out to yet another new high. No one knows with certainty which course the markets will take. But that just reinforces the need to have someone actively monitoring your accounts so that they are more likely to be positioned to reflect the best probabilities for the future.

Is this the beginning of a bear market or just a correction? Is the market just consolidating and still in a bull market? It all depends on your time horizon. It's all relative.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.