The Investor's Guide to Active Asset Allocation: Using Technical Analysis and ETFs to Trade the...

The Investor's Guide to Active Asset AllocationAllocation Using Intermarket Technical Analysis
and ETFs to Trade the Markets
Martin J. Pring
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Dedication To my daughter, Laura.
Copyright © 2006 by Martin J. Pring. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher.
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Contents
1. Some Basic Principles of Money Managements 1
2. The Business Cycle: Nothing More than a Seasonal Calendar 23
3. Useful Tools to Help Us Identify Trend Reversals 47
4. Putting Things into a Long-Term Perspective 73
5. How the Business Cycle Drives the Prices of Bonds, Stocks, and Commodities 101
6. Say Hello to the Martin Pring’s Six Business Cycle Stages 123
7. How to Recognize the Stages Using Models 141
8. Identifying the Stages Using Market Action 171
9. How the Stages Can Be Recognized Using Easy-to-Follow Indicators 185
10. If You Can Manage the Risks, the Profits Will Take Care of Themselves 201
11. How the 10 Market Sectors Fit into the Rotation Process 233
12. Sector Performance through the Six Stages 251
13. What Are Exchange Traded Funds? What Are Their Advantages? 275
14. How to Use ETFs in the Sector Rotation Process 295
15. ETFs and Other Vehicles as Hedges against Inflation and Deflation 321
16. Putting It All Together: Suggested Portfolios for Each Stage in the Cycle 335
Index 365
Introduction
Introduction The CD at the Back of This Book Strategic versus Tactical Asset Allocation Why Do We Need to Allocate Assets? The Seasonal Approach to Asset Allocation Investing Is as Much about Psychology as Applying Knowledge
Introduction
Have you ever been in a situation where you were listening to a business program on TV or reading a financial article in a newspaper and were totally confused about how the people concerned came to their conclu- sions? You probably heard comments such as, “Well, Jack, I think the market is going up because consumers are starting to get optimistic about the economy, corporations are likely to spend more on plant and equipment, and” blah, blah, blah. The analysis from such opinions is typically subjective, as the view is based on stringing together a host of factors that the person believes will affect the particular market in question. They are confusing because they fail to offer a way in which you can use this grab bag of ideas and facts to make forecasts at a later date. To make matters worse, such opinions are rarely backed up by proof that consumers are going to spend more, or even if they do, that this relationship has worked in the past. Indeed, the pickup in spending may already be factored into the stock market, which almost always looks ahead. I call it mouthing from the hip. Take the oil argument, for example. Lots of commentators will use the rising price of oil as the basis on which to make a forecast of a recession. “In the past we have had a recession whenever the price of oil has risen by so and so.” Could it be that the recession was really caused by the deflationary
v
effects of rising commodity prices in general, of which oil is just one component? Chart I-1 shows that oil and the CRB Spot Raw Industrials (a broad commodity measure that does not include oil) often rise and fall in tandem. It is not a perfect correlation, but it certainly illustrates the point that oil is not the only suspect.
The explanation in this book comes at the subject from a totally different angle. We will do our best to avoid such lose thinking by establishing that there is, generally speaking, a certain degree of order in the markets and the economy. We will show, for example, that the business cycle goes through a set series of chronological events or economic seasons. The calendar year moves through the four seasons and each one has specific characteristics where it is the best time in the year to carry out certain tasks. We generally sew seeds in spring and harvest them in the summer or fall. Rarely would we sew them in winter, for in most situations they would be destroyed. The same is true for the business cycle. There are specific times when you want to own lots of bonds and income-producing assets and times when you should own commodities or resource-based stocks instead. Our objective here is to explain the characteristics of these “economic” seasons and to lay out some techniques that can help us identify them. A
vi THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
Chart I-1 CRB Spot Raw Materials versus Spot Crude Oil (Source: pring.com)
calendar tells us about the 12 months of the year and how they fall. Our task here is to set up a framework for the economy and financial markets so you can see where they fall. In effect you will be provided with a road map that can be used as a basis for allocating and rotating assets during the course of a typical business cycle.
We know from historic records that the seasons begin with spring and end with winter. Does that mean that every time we plant corn in the spring that we are guaranteed to harvest it in late summer or early fall? In the vast majority of cases the answer would be yes. After all, if the probabilities of planting corn and harvesting it were not favorable, it would not be planted in the first place. However, in some years it is possible that drought or other extreme weather conditions will severely affect the harvest, in some extreme cases wip- ing it out altogether. The same can be said of our seasonal approach to the markets. Most of the time this methodology works. We can see this from the rates of return from our barometers featured in Chapter 7. However, there are exceptions where markets do not respond to the economic and monetary environments in the traditional and expected way. A great example occurred in 1968, when interest rates rallied at a time when the economic conditions suggested otherwise. These exceptions are a fact of life and develop with any methodology. However, we can minimize the damage in two ways: First our approach uses an escape hatch in the form of long-term trend- following indicators, just as a fighter pilot has an ejection mechanism.
Second, during the course of the cycle, different financial assets are going their separate ways and occasionally moving in tandem. We can use ratios of some of these key relationships as cross-checks. To site an obvious example, during the inflationary part of the (four-year) business cycle, the ratio of commodities to bonds should be rallying in favor of commodities; during the deflationary part, bond prices should have the upper hand, and so forth. These intermarket relationships are important to our approach because they act as cross-checks against what the economic and monetary indicators tell us should be happening. Remember, it is the markets and the action of the markets that should have the final word. For example, it’s possible to say that the law will protect you at a pedestrian crossing, but if a car is heading straight for you, you need to get out of the way. It’s no good being protected by a law when you are dead! Consequently, if the economic and monetary indicators are pointing in one direction and the market itself is not responding or confirming, we need to go with the market’s decision because that is where our money is. It is certainly not invested in the economic and monetary indicators. It is the attitude of participants to the emerging fundamentals that take precedence over the fundamentals themselves. If the fundamentals were the only consideration, it would not be possible for market bubbles or busts to exist because rational thought would predominate. Bubbles and busts are irrational, as are market participants from time to time.
Introduction vii
The process of pricing in markets is one in which people look ahead and anticipate what is likely to happen. The hopes and fears of all market participants, whether actual or potential, are reflected in one thing and that is the price. People do not wait for things to happen; they discount events and news ahead of time. This is how we can account for the fact that a stock price declines after the announcement of favorable earnings. In such situations the good news has already been discounted by the market and participants are looking ahead at the next development. If it’s not so favorable, the stock is sold and the price declines. Alternatively, the earnings may be poor and the stock rallies. Often this is a result of money managers knowing that a disappointment lies ahead. Because they do not know the degree of disappointment, they postpone their purchase until the bad news is out of the way. If it is in the realm of reasonable expectations, they immediately buy from a public that is eager to sell due to the “unexpected” bad news.
In this book we are principally concerned with fixed-income securities and equities. However, because new vehicles have recently been introduced that allow smaller investors to conveniently purchase broad baskets of commodities and gold, this is also a relevant area to pursue. We will also take a close look at the vehicles that will help us achieve these goals, as well as explain the workings of the business cycle and the investment implications for specific phases. For the most part, these will be the Exchange Traded Funds or ETFs. ETFs began to gain a following at the start of the century. They have the look and feel of stocks because they are listed on the major exchanges and are quoted and traded on these exchanges on a daily basis. They are continually being priced just like any other listed entity while the exchanges are open. They differ from open-ended mutual funds, which are valued only once a day. Most ETFs also pay dividends. However, their claim to fame is that they are really a basket of specific stocks that exactly replicate an index. This could be a measure of the market like the S&P or a specific sector, such as energy, financials, etc. These vehicles are also available for bonds, gold, and non-U.S. stock indexes. In all there are over 200 vehicles and the selection keeps growing every year. ETFs therefore represent a quick, easy, and affordable method for owning a basket of diversified securities aimed at a specific index.
The CD at the Back of This Book
At the back of this book you will find a CD-ROM that contains a substantial amount of information to supplement explanations given in the book. Included are historical data files for some of the economic, monetary, and market indexes described. The CD also contains live Web site links so that the data can be updated.
viii THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
There are several chapters devoted to Exchange Traded Funds, so links to various ETF families are included, along with information on the S&P and Dow Jones industry group classifications. Links to industry group components have been provided.
Unfortunately, the book is limited to a black-and-white format, which does not do justice to many of the charts. For this reason a wide-ranging library of multicolored charts has been included in PDF format on the CD. Many of these charts are not included in the book. All in all the CD will provide you with some really helpful background information to assist in the execution of the strategies described in the book.
Strategic versus Tactical Asset Allocation
A successful investment strategy should be aimed at maximizing return but not at the expense of undue risk. One way of achieving this is to allocate assets among several investment categories. The degree of “undue” risk depends on an individual’s psychological makeup, financial position, and stage in life. If you are young, you can assume greater risks than someone who is retired, simply because you are in a position to recover from a sharp loss. Time is on your side. On the other hand, if you are close to retirement, you do not have the luxury of time. Alternatively, a highly paid executive will be less dependent on current portfolio income than will a disabled person on workmen’s compen- sation. The executive’s position therefore allows him to take a more aggressive investment stance, and so forth.
The asset allocation process initially involves two steps. First it’s necessary to make a general review of the three aspects discussed in the preceding para- graph: personal temperament, financial position, and stage of life. From here you can establish a broad goal. Is it current income or capital appreciation, or a balance of the two? If you decide on capital appreciation, it is important that you have the personality to ride out major declines in the market. On the other hand, would you be better off assuming less risk in order to sleep more peacefully? There is only one person who can make such decisions, and that is you. So look into your financial position, psychological makeup, and stage in life and decide for yourself. This process of formulating an investment objective is known as strategic asset allocation. It is a process that sets out the broad tone of your investment policy, and one that should be reviewed peri- odically as your status in life changes. We offer some guidelines on these aspects in the final chapter of this book.
Tactical asset allocation is the process in which the proportion of each asset category held in the portfolio is altered in response to changes in the business climate. Thus, an older person may be principally concerned with income and safety while a younger one with risk-taking and capital appreciation. When
Introduction ix
the stage in the cycle that favors the stock market is reached, both parties would increase their exposure. The difference would be that conservative investors would take on a smaller position, say from 10%-30% of the portfolio, Compare this to risk takers, who might increase their exposure from 50% to 80%. In effect the level of equity allocation is increased by both parties through the tactical asset allocation process, but the strategic allocation deter- mines that the more conservative people increase their very low exposure to low, whereas younger people fluctuate between high and very high.
Once again we can come back to a seasonal analogy. For example, people in Florida and New England make strategic decisions about what clothes to own. New Englanders will have a good supply of heavy coats, thick sweaters, and ski jackets, whereas Floridians will have only thin jackets and the occa- sional thin sweater. However, in the winter months both will switch to winter clothes. This is the tactical choice. New Englanders will wear their heavy overcoats, etc., whereas Floridians will move from short-sleeved shirts and short pants to long-sleeved shirts and long pants, and perhaps a thin sailing jacket. Both are allocating their clothing assets for winter wear because that is the prevailing season. However, the New Englander wears much heavier clothes because the climate requires such a strategic approach.
Why Do We Need to Allocate Assets?
There are three reasons why it makes sense to allocate assets. First, it is a well- known investment principle that risk is reduced when a portfolio is diversified into several different entities. It comes down to the simple idea that if you own one stock and the company goes bankrupt, you have lost your entire portfolio. On the other hand, if you own eight stocks and one goes bankrupt, the portfolio is hurt, but not mortally. The second justification for allocation is to take advantage of times when an asset is attractive and to avoid that same asset class when it is not. Finally, the key to successful investing is as much about dealing with yourself and remaining objective as it is about attaining knowledge. Grad- ually and carefully shifting emphasis from one asset to another will really help to reduce the emotional aspect of decision making. Our seasonal approach and the framework it provides will give you the confidence of understanding where you are in the cycle and what conditions should be expected. The rotation and balancing of assets should become a much more understandable process from which it is possible to gain a high degree of confidence.
The Seasonal Approach to Asset Allocation
A significant part of this book is devoted to optimizing the allocation of a portfolio’s assets based on the changing character of each unfolding business
x THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
cycle. The application of this approach assumes two things. First, and most importantly, that the business cycle will continue to operate. The cycle has been a fact of life throughout recorded economic history, not only in the United States but in every other capitalist country. Typically it encompasses a time span of roughly four years from trough to trough, and is a reflection of human nature in action as businesspeople alternate between moods of vary- ing pessimism during recessions to outright greed and irrationality in boom times. Because human nature remains more or less constant, there are few grounds for expecting that the business cycle will ever be “repealed.” There is no doubt that the nature of each successive cycle will continue to change as it has in the past, but unless human nature experiences a radical alteration, the cycle is likely to stay with us permanently.
The second assumption is that every cycle progresses through a set, chronological series of events, each of which greatly affects the performance of specific asset classes. Later on we will take a look at these events and discover how they may be recognized. Like the seasons of the calendar year, the business cycle provides an optimum time for buying and another for liquidating specific asset classes, such as bonds, stocks, commodities, or even individual stock market sectors. If you are familiar with the kind of crops that are suitable for the local soil and climate and know when to plant and harvest, barring an unforeseen natural disaster, it should be possible to obtain reasonable yields. In this connection successful investing is no different than successful farming. If you have an understanding of the characteristics of the various asset classes and can identify the points in the business cycle when they traditionally do well, it is possible to attain superior returns relative to the risk undertaken. Because they vary more in length and intensity, the business cycle “seasons” are not as predictable as those in the calendar year. We also have to recognize that occasionally our approach does not work. Unfortunately that is a fact of life. However, the guidelines we are offering will provide enough information to identify the various business cycle seasons together with the type of performance to be expected from each asset class during specific stages of the cycle. We will discover the time to emphasize stocks over bonds and which sectors to focus on. Winters are a time for less or even no activity for most farmers. This is because the risk of growing most crops is high. There is also a season in the business cycle when risk taking in any asset should be kept to an absolute min- imum. This means loading up with cash and waiting for the next opportunity.
Successful Investing Is as Much about Psychology as Applying Knowledge
It is a relatively easy task to read a book such as this and obtain a theoretical understanding of why markets rise and fall. Beating the market on paper is
Introduction xi
not that difficult. The trick is applying that knowledge on a day-to-day basis and overcoming our own psychological deficiencies, and it’s a difficult one to pull off. The reason is that as soon as money is committed to an investment, so is emotion. Before money is committed, a declining price does not bother us, but once we have money on the line and prices sell off, it is human nature to be adversely affected by such a development. Just think of a little thing like the sleep-at-night factor for instance. It makes little sense to embark on a potentially highly profitable investment if the slightest price setback causes you to sell at the wrong time. It is paramount for each of us as individuals to assess the amount of risk that we can deal with comfortably and the kind of rewards commensurate with those risks. The investment objective and the ability to take on risk will very much depend on our individual financial position, emotional makeup, and stage in life. Nervous Nel- lies should not expose themselves to a lot of risk, and neither should retirees who obtain most of their income from investments. By the same token, you might be one of those people who has an aggressive, energetic nature and decide to (uncharacteristically) invest in ultra high quality “dull” blue chips during the early stages of a bull market. The chances are that you will be bored with the performance of these investments and decide to move into more aggressive stocks after prices in general have moved substantially higher, exactly at the wrong time. The key is to decide ahead of time your level for risk tolerance and tendency, if any, to jump in at a moment’s notice. If you can establish personal psychological traits such as this and act accordingly, your success rate will undoubtedly be greater. For example, establishing a realistic assessment of your risk tolerance at the outset would remind you of the dangers of making a sudden and risky switch later on. One way around this is to design your portfolio to be a little more aggressive at the outset. To some extent this will satisfy your desire for the fast track.
The level of emotion is enhanced if we are constantly checking the latest prices. This type of practice ensures that we will react in a knee-jerk fashion to every twist and turn that the market throws at us. This means that we will move down from the high level of objectivity to one of subjectivity and loss of perspective as time horizons shrink. Of course we cannot look away entirely, as a regular judicious monitoring of the situation is a necessary part of the process. However, if we get too close to the market, the tendency is to respond to events and price changes instead of following a carefully laid plan that responds to changes in longer-term, more meaningful conditions. If you find you are always changing your mind, the chances are that you do not have a sense of perspective. The key is to set realistic goals and slowly work toward them. Make gradual and systematic changes in your portfolio based on changes in the indicators you are following. The best way to lose perspective is to make large and frequent changes.
xii THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
The approach described here should help in this direction. First, the very adoption of asset allocation principles and the seasonal approach implies the establishment of reasonable investment goals and the employment of a plan. If you make a plan and stick to it, you are far less likely to be side- tracked by the latest news and investment fashion. At Pring Turner Capital we are very enthusiastic about expanding our management base, but not at the expense of clients who do not sympathize with our approach. By believ- ing in our methodology, they are in a better position to understand our thinking and remain with us for the long term. The situation for individual investors should be the same. By having and understanding a methodology such as the one described here, you will not only have greater confidence in going forward, but you will be in a far stronger position to objectively and systematically allocate your assets profitably. One of the key ingredients of a successful salesperson is a complete understanding and confidence in the product being sold. One of the key ingredients of a successful investor is a complete understanding and belief in the methodology being used. With- out that confidence you will be easily put off track when things inevitably do not work out as expected.
If you comprehend the process you will also get to learn what is important for the long term and what is not. For example, in recent years the monthly employment payroll numbers have become notorious as market movers. However, payroll numbers are a coincident indicator of the economy. They are an indication of where the economy is, not of where it is going. While surprises in this economic series undeniably move markets for a day or so, they rarely become beacons of fundamental changes in the economy. Perverse reactions to these numbers often provide buying or selling opportunities for those following the slow ebb and flow of the economy.
The process of asset allocation, on the other hand, involves a slow but steady rotation of asset classes as evidence of changing conditions gradually emerges. This measured shift means that the emotional ups and downs will also be less intense because the stakes of any specific change will be limited.
Some individuals have been highly successful trading markets over the very short term. To do so they must focus 100% during the trading session. Most of us do not have the time to apply such intensity of effort. Fortunately, history shows that the majority of successful investors have been those who have con- centrated on the long term, by which I mean six months or more. We all know that the media have a tendency to glorify the money managers or mutual funds that have outperformed the pack over the latest quarter or so. In reality, near-term variations in performance are heavily influenced by chance or by the temporary success of the investment philosophy or style favored by such managers. Those specializing in smaller companies are bound to have their performance lifted when these stocks come into fashion. The great temptation we all have is to compare our own performance with the latest
Introduction xiii
investment stars. Such an exercise is doomed to futility. With very few exceptions, studies continually show that, over the long haul, most money managers underperform the market. Equally as important, those that beat the market in one period have a less than even chance of doing it in the next, purely and simply because investment styles and fashions change.
A common problem for many investors is not getting into a position but getting out. The purchase decision is often based on sound logic, but investors rarely ask themselves the question under what conditions they should liquidate it if their expectations are not realized. Establishing benchmarks for these situations is a mandatory requirement for risk control. Benchmarks convert the investment from an open-end risk into a manageable known one. It doesn’t matter whether such yardsticks are based on market prices, economic indicators, valuation measures, etc. The important point is that they should represent logical, soundly based crite- ria that not only help to define the risk in question, but also enable you to sleep more easily at night in the full knowledge that the risk is limited.
If you think that rapid and dramatic shifting of assets is a necessity for beating the market, you need to think again. In reality, success in any ven- ture is achieved at the margin. This is especially true for market success where the tortoise approach implied by a gradual and continuous reallocation of assets will, in the long-term, beat the investment hare.
xiv THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
1 Some Basic Principles of
Money Management
Introduction Diversification
Psychological Barriers to Diversification The Investor’s Two Biggest Enemies: Inflation and Volatility and How Diversification Can Help Using Diversification to Reduce the Risk from Owning Individual Companies Using Diversification to Reduce Risk from Market Fluctuations Diversification Can Result in Bigger Gains as Well as Smaller Losses! ETFs and Diversification
The Power of Compounding Compounding and Interest Compounding and Dividends
Introduction
A couple of decades ago I was driving from the airport with a client and his Swiss banker. We were going over the incredible performance that we had achieved in a matter of less than six months. He remarked that in order to achieve such a performance I had to have taken a tremendous amount of risk. That statement has stayed with me ever since because it is not something I had thought about at that time, and yet cutting losses and managing risk is the first rule of investing. I had been focusing on the reward side of the equation, alsost totally unaware of the risk. I had made money for my client, not because of any exceptional skill but because I had been extremely lucky. Leverage works both ways and I had enjoyed the positive aspects. I was soon to learn the negatives, but that’s another story. However,
1
it does underscore the point that when committing money to the markets, most people focus on how much they are likely to make. Professionals, on the other hand, first ask how much risk they need to undertake in order to achieve those gains. If the risk is determined to be too great, the investment is not made.
This means that once you have established that the conditions for a specific investment are positive, the final step before committing money is to set up an exit strategy. If you are sympathetic to the technical approach of market analysis, this would involve searching for a chart point below which a change in trend would be signaled. A stop loss would be set accordingly. If you are not technically oriented, you do not have the luxury of setting a specific price level. You will need to tackle the problem another way by establishing the reasons why you are investing in that particular entity and then deciding what would have to happen for those conditions to no longer be in force. If and when that happens you would have mentally rehearsed your exit strategy. In practical terms we have to take this risk management strategy one step higher by managing the risk of the overall portfolio.
There are a number of ways in which risk may be managed. The most obvious is to diversify into several asset classes so that the risk can be spread. A second method is to control the volatility of your portfolio. Stocks with a high gain potential often come with a commensurate degree of risk, measured as volatility. Reducing the number of such securities clearly reduces risk. Third, invest in assets only when the condition for that particular class is favorable. You wouldn’t think of planting seeds in the middle of winter when the snow is on the ground. Similarly, do not buy assets when the environment for them is unfavorable. The first two points will be dealt with in this chapter and the third throughout the rest of the book. First, though, let’s begin with the principle of diversification.
Diversification
There is a well-known saying that you should not put all your eggs in one basket. That principle applies very much to the investing process. This is because investing in more than one asset or asset class simultaneously helps to cushion your portfolio in case one of your holdings does not turn out to be as profitable as originally anticipated.
Diversifying means more than buying different stocks. It also involves cash, bonds, inflation hedge assets, and so forth. We could also include real estate, oil leases annuities, and many other types of assets in the mix, but these fall outside the scope of this book. Here we are concerned solely with bonds, stocks, cash, and commodity-related assets because these are all liq- uid, freely traded, and marked to market on a regular basis.
2 THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
One way of allocating assets is to use what we might call a “static” approach. Under this scenario we would hold a little of everything and never sell. Such a portfolio would limit losses from such events as the 2000- 2003 bear market in stocks or the 1987 crash, when the stock market declined by 25% literally overnight. By the same token it would have par- ticipated in the great bond bull market that began in 1981, in the 1970-80 bull market in gold, etc. However, such an approach suffers from two draw- backs, not to mention putting brokers and financial planners out of business! First, if one particular asset class does particularly well, it would increase its proportion of the portfolio well in excess of the original intention. Worse still this overweighting would take place at exactly the wrong time–i.e., when that particular asset was peaking. Our objective here is to increase the proportion of an asset when it is in the area of a major bottom, not a major peak. Eventually, the portfolio would have to be rebalanced or this static approach would lead to such inequalities that it would lose most, if not all, of its diversification qualities.
Equally as bad, the static approach fails to capitalize on emerging opportunities and offers little protection from downside risk. No approach is perfect. However, does it not make sense to make hay while the sun shines? In other words, when the economic, technical, psychological, and monetary environment turns positive, it makes sense to alter the asset balance in order to take advantage of such opportunities.
A key objective in the money management process is to improve the risk/reward ratio as much as possible. It’s not possible to avoid risk altogether, but if you can limit risk but not give up too much on the reward side, you are well on the way to success. Major buying opportunities arise when the news is blackest and market participants have responded by liquidating their stocks. One way of measuring these swings in sentiment is to plot a two-year change in prices. When the indicator is very low it indicates that sentiment is extremely negative and virtually no one wants to own equities. Chart 1-1 shows a history of this indicator back to 1900. When the ROC falls below –25% and then rallies above that level, this is usually a low-risk time for entering the market. Examples are flagged by the upward pointing arrows. Even though this technique has worked well in the 100 years covered by the chart, no investment approach is perfect. Just refer to the dashed arrow that gave a false buy signal in the late 1930s. Similarly, when prices have been rallying for a long time, investors become more confident and careless in their approach. That’s when the risk is greatest. The chart clearly shows that on those few occasions when the indicator has risen above the 50% level and then fallen below it, the risk has been high and the reward negative.
These examples have been flagged by the downward pointing arrows. The dashed arrows reveal those periods when weakness was incorrectly forecast.
Some Basic Principles of Money Management 3
This same data is reflected in Figure 1-1, where the annualized rate of return over the ensuing 24 months from these signals is represented on the y axis and the risk on the x axis. The place to be is high on the return and low on the risk. In effect, as close to the top left as possible, in the Northwest Quadrant as it is known in the investment business. The place to avoid is the Southeast Quadrant, where the risk is high and the reward low or negative. Obviously in the real world it is not possible to get to the extreme of the Northwest Quadrant, because there is always a trade-off. Fortunately there are some techniques at our disposal that help us to gravitate in this direction. This can be done through diversification and overweighting specific assets at the appropriate time in the business cycle. A final approach is to buy when an asset is historically cheap and sell when it is historically expensive. This does not mean buying at the bottom and selling at the top because what is cheap can become cheaper and, as we discovered in the late 1990’s tech bubble, what is expensive can become superexpensive.
A good example of the benefits of diversification can be seen by comparing Chart 1-2 to 1-3. Chart 1-2 shows the daily price action of Merck in 2004 and 2005. The downside gap at the end of September reflects some bad news when the company withdrew an important drug from the market. It could easily have been good news. The point being that investing in an
Chart 1-1 S&P Composite and a 24-Month Rate of Change (Source: pring.com)
individual stock can be more risky than you may have bargained for because you are always at the mercy of the market’s reaction to unexpect- edly bad news.
Chart 1-3 also shows some downside action at the end of September 2004, but this time it features the Holders Pharmaceutical ETF, a diversified portfolio of drug stocks that includes MRK. In this case the price drop was less dramatic. Whereas MRK had fallen from $44 to $33, the ETF was only down from $74 to $72, a difference between a 25% and a 2.7% loss. Quite often the spillover effect from one stock in an industry will be greater than this, but it is still substantially less risky than exposure to one stock. Note also that while the performance of neither series was very impressive in the ensuing period, that of the ETF was at least slightly positive.
Diversification can be justified on two grounds, partly on the factor of chance and partly to protect us from the possibility that our assessment of the situation turns out to be incorrect. Obviously when we purchase, say 12 different stocks the odds of the risk of a setback increases twelvefold. However,
Figure 1-1 Risk versus Reward for the S&P Yield 1948-1991 (Source: pring.com)
Chart 1-2 Merck (Source: pring.com)
Chart 1-3 HOLDRS Pharmaceutical ETF (PPH) (Source: pring.com)
the odds of the whole portfolio being wiped out are extremely low, substantially lower than if we were exposed to just one stock. By the same token we may think of diversification as the spreading of risk and limiting bad luck, but it also increases the chance that one of our stocks may be a big winner. One could be the beneficiary of a takeover, an oil find, a technological break- through, and so forth.
A hidden advantage of diversification is that it allows us to make gradual changes in our portfolios. Market conditions do not change overnight but move in a slow and deliberate fashion. Diversification permits us to rebal- ance the portfolio as more evidence of a change in economic, financial, or monetary conditions evolve. For example, we will learn later that market tops experience a gradual change of industry leadership as early cycle leaders peak out and late cycle leaders improve in relative action. If we were just exposed, say to a bank stock, an early leader, and felt that energy, a laggard, was about to emerge it would be a difficult call. However, if we are diversified into several groups it would be easier to gradually phase out of the early leaders as more evidence emerged.
Diversification needs to be a dynamic, not a static process. For example, we could be diversified in cash, bonds, and stocks, split into equal amounts. However, if the next 10-20 years is one of strong price inflation, such a portfolio could easily lose purchasing power. This is because the stock portion, which has traditionally beaten inflation over long periods, would not be sufficient to offset the decline in the income-producing assets, which are harmed by rising prices.
Psychological Barriers to Diversification
There are several reasons why diversification is not widely practiced, and they basically come down to one––laziness. In the most simple of terms it is much easier to buy a stock or asset that is presented to us in glowing terms by a media story, brokerage report, or a friendly “insider,” than to undertake some difficult and tedious research on a number of different stories from which we will make our final picks.
Alternatively, many are tempted to buy a particular asset theme. Perhaps the Administration is talking down the dollar. In anticipation there could be a rush to purchase companies that derive a substantial part of their profits from foreign currency sources. This may or may not be a perfectly legit- imate investment idea, but it is not a sufficient one to allocate all of our stock portfolio to exporters. Conceivably the news or its expectation may already be factored into the price. Perhaps our assumption is wrong because these foreign economies are just entering a slump and are not in a position to absorb our exports. In either situation this one-idea overly sim- plistic allocation strategy leaves no room for error.
A common mistake made by everyone is to extrapolate the recent past into the future. It’s easy to fall into this complacent mode because we are surrounded by commentators and media stories that are sympathetic to current trends. It’s not only easier to go along with the crowd, but the emerging economic statistics support such a view: nonfarm payrolls, indus- trial production, and so forth. Because the markets look ahead, this type of data has already been discounted. It might flinch for a day or two when unexpected numbers are published, but unless a particular number is the one that starts to signal a change in the economic environment, the market dye has most probably already been cast. The reason is that markets look ahead and are concerned with indicators that lead the economy, such as the Index of Leading Economic Indicators, money supply, housing starts, etc. By observing these leading economic series, it is possible to look ahead and anticipate possible changes down the road. For example, monetary policy leads the economy, and we may have noted that inflationary conditions are intensifying due to easy money policies adopted several months earlier. On the basis of this we may be tempted to buy precious metal shares. This decision may be perfectly sound, but only for a limited time because the economy, as we shall learn later, has its own self-correcting mechanisms. It goes something like this. The Fed injects liquidity into the system that eventually gets the economy going again. As the central bank realizes that commodity prices have started to rise and easy credit is no longer required, the price of credit, interest rates, start to rally. Eventually rising interest rates kill the commodity bull market because they curtail consumer spending and business investment. The economy then falls back into recession, interest rates decline, and the Fed adopts an easy money policy. Thus for every action there is a reaction. In effect we can say that every inflation eventually breeds its own deflation.
In this example the rise in prices causes interest rates to rise as well. Even- tually the higher rates make it unprofitable for businesses to invest and pro- hibitively expensive for consumers to borrow and the economy heads south. When this happens, inflation hedge assets suffer and deflation hedge assets come into their own. The investment in precious metal shares may do well for the time being, but by putting all your eggs in the inflationary basket, the final result will eventually turn out to be disappointing unless you are able to spot the change in the investment environment and take action accordingly.
Intellectual laziness can also be a barrier to diversification when an investor chooses to concentrate on one security or asset class in the hope of making a financial home run. Inevitably this quick reach for riches will fail. The demoralization caused by this failure will unbalance the emotional state of our investor. Under such circumstances it will be almost impossible to make any rational decisions. Performance is certain to suffer and valuable emerging new opportunities will be passed over.
Diversification involves a certain degree of patience, thought, and discipline. Unfortunately, beginning in the 1970s, the time horizon of most investors started to shrink. More recently the tech boom has placed the (perceived) virtue of instant analysis, quotes, and greater leverage at the fingertips of everyone, leaving us all to believe that fast and painless financial rewards are just around the corner. With such temptations in front of us, an even larger barrier to the principle of diversification has been thrown up.
In conclusion, profitable investing is best made in an environment of objectivity. Quick home runs and off-the-cuff analysis, where the focus is on profits, are not the way to achieve this. A far better approach is through a program of diversification, where assets are rotated slowly, incrementally, and thoughtfully. No single asset can make or break the portfolio, nor, by the same token, can it emotionally unbalance the investor.
The Investor’s Two Biggest Enemies: Inflation and Volatility and How Diversification Can Help
A history of the markets indicates that over the long haul the returns on stocks have been superior to both bonds and cash. However, it is possible to lose a considerable amount of money if stocks are bought and sold at an inopportune time because of their volatility. Bonds too can be volatile but, barring a bankruptcy, they always come back to their full face amount on maturity. Even where they sell at a premium the holder is assured of a rate of return throughout the life of the instrument.
In all cases, though, the longer the holding period, the lesser the volatility. Inflation can also adversely affect the purchasing value of a portfolio. It
is perhaps a more dangerous risk because it develops slowly over a long period of time, and unless the rate of inflation is particularly robust, it is almost invisible. In a sense, the inflation risk is inverse to that of volatility because the former becomes greater over time, whereas the passage of time reduces the effects of volatility.
Diversification can help reduce both problems. On the one hand, if a portfolio always includes some stocks and some bonds, the inclusion of bonds will cushion some of the effects of a volatile stock market. At the same time a portfolio that rotates part of itself over the course of the business cycle will be able to emphasize inflation hedge assets at the time of the cycle when inflation is emerging as a threat. This part of the portfolio could also include exposure to a mutual fund that seeks to replicate a commodity index. Alternatively, when deflation is the greater problem, deflation-sensitive assets such as bonds and utilities may be overweighted. Under such circumstances diversification becomes both a static and dynamic process.
Using Diversification to Reduce the Risk from Owning Individual Companies
The risk associated with individual companies independent of market fluctuations is known technically as unsystematic risk. It is generally accepted that risk declines as more stocks are added to the portfolio. Figure 1-2 demon- strates this principle, where the risk is measured on the y axis and the number of stocks on the x axis.
See how the average risk for the portfolio falls sharply with the addition of six stocks and then begins to flatten out. By the time seven or eight stocks are added there is very little to gain from risk reduction. Thus, from the point of view of the individual, it does not make much sense, from a risk management point of view, to increase the portfolio to more than nine stocks.
Using Diversification to Reduce Risk from Market Fluctuations
Diversifying into a number of different stocks does not necessarily protect you from a general market decline. This type of risk is called systematic risk.
In this instance we are assuming that these stocks are in different industries and sectors. For example, if the portfolio consists of nine issues, all of which are energy related, it will be very vulnerable, for example, if a sharp drop in oil prices takes place. This is because each of the components will
Figure 1-2 Risk versus Diversification (Source: pring.com)
be energy price sensitive to one degree or another. Such a portfolio would not fit the curve featured in Figure 1-1. In this instance the curve would probably experience a shallower descent and would certainly flatten out at a higher (i.e., more risky) level.
On the other hand, if these nine stocks were representative of nine widely differing industries or sectors, the effect of diversification would be far more beneficial. This is because specific adverse industry developments would be cushioned by the other stocks in the portfolio. However, because these industries would represent a reflection of the overall market, they would not offer much in the way of protection from a general market decline.
This problem can be addressed by including other asset classes. The degree of systematic (market) risk can therefore be controlled by changing the balance of the assets it contains. This is only possible because bonds, stocks, and commodities are often moving in different directions. Cash, our fourth asset, is always static, of course. The concept of similar and dissimilar price movements simultaneously taking place is known as correlation. In our example discussed earlier, the nine energy stocks would be closely correlated. Let’s call this portfolio A. On the other hand, the nine securities in the widely diversified stock portfolio would not. Let’s call this one portfolio B. Taken together, though, portfolio B would closely correlate with overall market movements.
A well-diversified portfolio should therefore be balanced to include assets that are not closely correlated. Thus if one asset, say stocks, is per- forming poorly, the diversification implied in portfolio B will not be of much help. However, if this is combined with an asset that does not closely correlate with stocks, say precious metals or cash, the portfolio will be to some degree cushioned.
Table 1-1 shows several asset classes and how they correlate. A perfect correlation is indicated by 1.0. Thus aggressive growth correlates perfectly with aggressive growth, as does money market with money market. The lower the number, the weaker the correlation. In this case the weakest correlation is between growth and money market at -.0.09.
Diversification really comes into its own when the correlation between asset classes and industry groups is greatest. If the correlations are high, this means that the performance will be very similar, so not much will be gained from diversification. This is a major reason why an investor is advised to maintain some portion of the portfolio in each principal asset class. In this way the overall performance is hedged in the event that an incorrect market call is made in any asset class.
Returning to Table 1-1, it is possible to use the data by way of an example. Let’s say for instance that a retiree requires substantial income. His stage in life immediately places him in the conservative camp. He obviously requires an income-producing asset. Corporate bonds represent an
acceptable vehicle. Putting all of the assets into corporate bonds would give him lots of income but no protection against rising rates. Precious metals correlate poorly at 0.07 and would offer some sensible diversification because they move in the same direction as corporate bonds less than 10% of the time. While they provide a hedge against inflation, their income stream leaves a lot to be desired. Cash (0.04) and growth and income (0.51) would also represent good diversification because each has an income component, important to our investor, and neither correlates closely with corporate bonds.
Correlation can also be extended to the equity market. Most people refer to it as the “stock market.” However, it is more like a market of stocks, where companies in different sectors are simultaneously going their different ways within given time frames. Obviously there are bull markets, where most issues are rising most of the time, and bear markets, where the opposite conditions hold. However, there remains a dichotomy of performance among the individual industry groups and their component stocks. Consequently, it makes sense to construct a portfolio among industry groups with a low correlation. For example, utilities tend to outperform the averages during the late stages of the bear market and the early phase of a bull market, when the economy is typically in a recession. On the other hand, energy stocks put in their best relative performance when the economy is close to capacity and pricing pressures are greatest. That is also a time of rising interest rates, which adversely affect the high-dividend-pay- ing and capital-intensive utilities. Just look at the diverging paths of the two momentum indicators reflecting disparate industry groups in Chart 11-14 (in Chapter 11).
Table 1-1 Correlations of Various Asset Classes
Aggressive Corporate Growth Growth and Precious Money Growth Bond Income Metals Market
Aggressive 1 0.4 0.99 0.95 0.42 –0.07 Growth
Corporate 0.4 1 0.43 0.51 0.07 –0.4 Bond
Growth 0.99 0.43 1 0.98 0.42 –0.09 Growth and 0.95 0.51 0.98 1 0.39 –0.08
Income Precious 0.42 0.07 0.42 0.39 1 –0.08 Metals Money –0.07 0.04 –0.09 –0.08 –0.08 1 Market
Diversification Can Result in Bigger Gains as Well as Smaller Losses!
Diversification, when correctly applied, reduces risk, but it does not necessarily imply smaller rewards. In fact, it is possible to enhance the performance. For example, if we are interested in including a small cap growth stock, the volatility of the portfolio is obviously increased. The result could be spectacular gains or it could all end in tears. However, if we take this same allocation and spread it among several stocks, we may still reap most of this reward yet better manage our risk. For example, let’s say we buy 10 promising growth candidates. It’s probable that one or two of them will turn out to be a dud, that most of them will be mediocre, and that possibly one or two might experience substantial gains. At first glance it may appear that this will result in a zero sum game, but that is not the case. This arises because it is quite realistic to expect a good company to gain two to three or more times in price over, say a three-year period. By the same token, some of the losers may drop by 40-50%, but they are unlikely to go bankrupt. If one does, the $10 stock that goes to zero is more than outweighed by the $10 stock that moves to $30.
Table 1-2 shows that even with one issue losing $12 for a 100% loss and two others experiencing sizeable losses, the overall portfolio still experiences a nice 11% gain.
ETFs and Diversification
One way of obtaining diversification in one easy stroke is to purchase securities that already have a diversified portfolio. Years ago this involved buying a
Table 1-2 Diversified Portfolio of Aggressive Stocks
Cost ($) Gain or Loss (%) Market Value
Company 1 12 100 24 Company 2 12 50 18 Company 3 12 –100 0 Company 4 12 –25 9 Company 5 12 –33 8 Company 6 12 50 18 Company 7 12 15 13.8 Company 8 12 15 13.8 Company 9 12 15 13.8 Company 10 12 15 13.8 Company 11 12 15 13.8 Company 12 12 15 13.8
Total 144 159.8 PROFIT $15.8 (11.0%)
broadly based mutual fund, either directly or indirectly from a mutual fund company or as a mutual fund listed on an exchange. The former are called open-ended funds because their size is literally open ended. As new money pours in, so the fund grows in size, provided, of course that new money is not dwarfed by redemptions. Funds listed on the exchanges or over the counter are known as closed-end funds because their portfolio size is set at the time of listing. They are pools of professionally managed investment capital that have a fixed number of shares that can only be purchased from other sharehold- ers. The capitalization of these funds, barring the raising of new capital through subsequent offerings, is therefore closed. The principal difference between the two is that closed-end funds can be purchased any time the exchange is open, whereas open-ended funds can only be bought and sold after the market has closed. When sales commissions are not involved, as with no load open-ended funds, these securities always sell at net asset value––i.e., the value of the fund based on previous closing prices. Closed-end funds, on the other hand, sell at a premium or discount to their net asset value, depending on investor attitudes. If they are bearish the fund sells at a discount to net asset value and if they are optimistic at a premium.
Both types of funds offer special baskets of targeted securities, such as type of capitalization, low cap/high cap, country, Japan/Brazil, etc., differing types of fixed income (corporate/tax free) and so forth. They therefore offer some measure of diversification.
The latest kids on the block are the Exchange Traded Funds (ETFs). These are described at great length later in the book, but for our purposes here they may be regarded as possessing the characteristics of a closed-end fund that never trades at a significant premium or discount to the targeted index. They also have lower management fees. ETFs then are a great way to obtain some quick diversification because they embrace a substantial number of asset pos- sibilities such as cap plays, sectors, industry groups, country indexes, and fixed income. We will have much more to say about them in subsequent chapters.
The Power of Compounding
It is normal to think of investing as primarily returning capital gains, but current income should by no means be overlooked because the compounding factor of interest and dividends can be a significant ingredient in the long-term performance of a portfolio. We alluded earlier to the fact that time horizons have shortened with the ability of technology to present us all with instant analysis, quotes, and news. This is a shame because compounding requires a large amount of time, together with the discipline and patience to take advantage of this important investment principle, and that is not within the grasp of most investors today.
Compounding and Interest
Once you receive interest or dividends you are faced with a choice: spend the money or reinvest it. If you are in a position to reinvest your money, it will obviously grow faster, but probably faster than you might think due to the interest-on-interest effect.
We can see this from Table 1-3. In column four the cumulative total increases only by the amount of the payment. This compares to column seven, which reflects the reinvested proceeds as interest is earned on interest. As with all compounding effects, the difference is very small at the beginning but gradually increases with the passage of time.
The timing of interest payments can also influences the performance. The payments in Table 1-3 were made annually, but most bond payment sched- ules are done on a semiannual basis. This comparison is made in Table 1-4. The importance of the timing of interest payments can also be appreciated from this example. Suppose we assume that there are two $1,000 investments, one pays monthly (such as ETF bond funds), and the other annually. The final return, assuming a 10% coupon and a 20-year holding period, would be $7,328 for the monthly payer compared to $6,727 for the annual payment, a difference of almost 10%.
A third factor affecting compounding is the nominal interest rate, which can have the biggest effect of all. To give you an example, let’s assume that the original investment is $1,000. It pays on a monthly basis and the holding
Table 1-3 Comparison between Yield on a Single Payout and Reinvested Payout at 8%
Single Payout Reinvested Payout
Capital Annual Cumulative Annual Capital with Cumulative Value Payout Total Payout Payout Total of
Payouts Reinvested Payouts
Year 1 $10,000 $800 $800 $800 $10,800 Year 2 $10,000 $800 $1,600 $866 $11,664 $1,664 Year 3 $10,000 $800 $2,400 $933 $12,597 $2,597 Year 4 $10,000 $800 $3,200 $1,008 $13,605 $3,605 Year 5 $10,000 $800 $4,000 $1,088 $14,693 $4,693 Year 6 $10,000 $800 $4,800 $1,175 $15,869 $5,868 Year 7 $10,000 $800 $5,600 $1,270 $17,139 $7,138 Year 8 $10,000 $800 $6,400 $1,371 $18,510 $8,509 Year 9 $10,000 $800 $7,200 $1,481 $19,990 $9,990 Year 10 $10,000 $800 $8,000 $1,599 $21,590 $11,589 Total $100,000 $8,000 $44,000 $11,591 $156,457 $55,653
period is 20 years. This would grow to $2,996 with a 51⁄2% interest rate, $4,036 with a 7% rate and, as we saw in the previous example $7,328 with a 10% rate.
Unfortunately, compounding in practice is not as simple as these examples would have us believe. This is because there is usually a cost involved in reinvesting the proceeds. For example, bonds are usually sold in round amounts of $1,000 face value. If you do not have enough to purchase a round lot such as this you are out of luck. Also, even if you do have the required amount it will still be necessary to incur a transaction cost in order to purchase the bond. We have not begun to mention state and federal income tax on monies received in non-tax-exempt accounts that cannot be reinvested, nor the inability to reinvest in the event that the general level of interest rates falls during the lifetime of the bond.
One way around some of these problems is to invest in ETF bond funds, which permit the accumulation of odd dollar amounts, but taxes and com- mission costs still apply.
Table 1-4 Table of Annual Yield Equivalents
Semiannual versus Annual Yield Equivalents (Yield Based on Annual Compounding Equivalent to Stated Semiannual Yield)*
Semiannual Annual Semiannual Annual Semiannual Annual Yield Yield Yield Yield Yield Yield
3 3.02 7 7.12 11 11.3 3 1/4 3.28 7 1/4 7.38 11 1/2 11.57 3 1/2 3.53 7 1/2 7.64 11 1/2 11.83 3 3/4 3.79 7 3/4 7.9 11 3/4 12.1 4 4.04 8 8.16 12 12.36 4 1/4 4.4 8 1/4 8.42 12 1/4 12.63 4 1/2 4.55 8 1/2 8.68 12 1/2 12.89 4 3/4 4.82 8 3/4 8.94 12 3/4 13.16 5 5.06 9 9.2 13 13.42 5 1/4 5.32 9 1/4 9.46 13 1/4 13.69 5 1/2 5.58 9 1/2 9.73 13 1/2 13.96 5 3/4 5.83 9 3/4 9.99 13 3/4 14.22 6 6.09 10 10.25 14 14.49 6 1/4 6.35 10 1/4 10.51 14 1/4 14.76 6 1/2 6.61 10 1/2 10.78 14 1/2 15.03 6 3/4 6.86 10 3/4 11.04 14 3/4 15.29 7 7.12 11 11.3 15 15.56
* The nominal annual yield tabulated here assumes semiannual compounding. If interest rates were com- pounded only once a year, the nominal rate would be slightly higher. For example, an 8% yield assuming semiannual compounding is equivalent to an 8.16% yield assuming annual compounding.
The purest method is to purchase zero coupon bonds, the mechanics of which are discussed in Chapter 10. With zeros the compounding effect is built into the price, as is the assumption that the prevailing rate of interest rate remains constant. The problem with zeros that are not held to maturity is that they are extremely price sensitive to changes in the level of interest rates, and that works both ways.
Investing a lump sum and watching the investment compound is only one alternative; many people set up plans that require regular fixed contributions. The compounding effect of such plans can be truly remarkable. One of the most impressive compounding tables I have ever seen is based on statistics provided by Market Logic of Fort Lauderdale Florida (Table 1-5). It shows that a few early contributions can be far more effective than many later ones. The table, which assumes a 10% reinvestment rate, presents us with two investors. The first makes a total contribution of $14,000 and the
Table 1-5 Regular Contributions and Compounding
Investor A Investor B
8 0 0 0 0 9 0 0 0 0
10 0 0 0 0 11 0 0 0 0 12 0 0 0 0 13 0 0 0 0 14 0 0 0 0 15 0 0 0 0 16 0 0 0 0 17 0 0 0 0 18 0 0 0 0 19 2,000 2,200 2,000 0 20 2,000 4,620 2,000 0 21 2,000 7,282 2,000 0 22 2,000 10,210 2,000 0 23 2,000 13,431 2,000 0 24 2,000 16,974 2,000 0 25 2,000 20,872 2,000 0 26 0 22,959 2,000 2,200 27 0 25,255 2,000 4,620 28 0 27,780 2,000 7,282 29 0 30,558 2,000 10,210 30 0 33,614 2,000 13,431
(Continued)
Table 1-5 Regular Contributions and Compounding (Continued)
Investor A Investor B
Age Contribution Year-End Value Contribution Year-End Value
31 0 36,976 2,000 16,974 32 0 40,673 2,000 20,872 33 0 44,741 2,000 25,159 34 0 49,215 2,000 29,875 35 0 54,136 2,000 35,062 36 0 59,550 2,000 40,769 37 0 65,505 2,000 47,045 38 0 72,055 2,000 53,950 39 0 79,261 2,000 61,545 40 0 87,187 2,000 69,899 41 0 95,909 2,000 79,089 42 0 105,496 2,000 89,198 43 0 116,045 2,000 100,318 44 0 127,650 2,000 112,550 45 0 140,415 2,000 126,005 46 0 154,456 2,000 140,805 47 0 169,902 2,000 157,086 48 0 186,892 2,000 174,995 49 0 205,518 2,000 194,694 50 0 226,140 2,000 216,364 51 0 248,754 2,000 240,200 52 0 273,629 2,000 266,420 53 0 300,002 2,000 295,262 54 0 331,091 2,000 326,988 55 0 364,200 2,000 361,887 56 0 400,620 2,000 400,276 57 0 440,682 2,000 442,503 58 0 484,750 2,000 488,593 59 0 533,225 2,000 540,049 60 0 586,548 2,000 596,254 61 0 645,203 2,000 658,079 62 0 709,723 2,000 726,087 63 0 780,695 2,000 800,896 64 0 858,765 2,000 883,185 65 0 944,641 2,000 973,704
Less Total Invested –14,000 –80,000 Equals Net Earnings 930,641 893,704 Money Grew 66-fold 11-fold
second a total of $80,000, yet they both end up about the same in total dol- lars. The difference, is that investor A makes his contributions between the ages of 19 and 25, whereas investor B pays the same annual $2,000 but pays from age 26-65. Logic would suggest that the second investor, who makes a substantially larger contribution, would end up with a significantly larger portfolio but that is not the case. He does end up with a slightly larger total, but when the contributions are deducted investor A wins out handsomely with a 66-fold increase compared to investor B, who only achieves an 11-fold gain. This table was first calculated when the general level of interest rates was much higher than at the time when this book is being published, but the same principle, that the early bird gets the worm would still apply, just that the returns for both parties would be considerably less.
Compounding and Dividends
When we think of compounding it is usually interest earned on principal and accumulated interest reinvested from prior periods that come to mind. However, the compounding element of dividends over long periods of time can also play an important role in the total return. Dividend reinvestment is usually a dynamic process. This is because it does not just include the compounding of reinvested dividends, but dividends themselves increase over the years. A growth company does not typically offer a very high dividend yield, but if it is truly growing it will increase those dividends on an annual basis. After a period of 10 years or so the current dividend could offer a huge yield based on the original investment. Let’s say you invest $100 in year one and the dividend yield is 2% or $2. Let’s also say that the dividend is increased by 10% per annum.
Year 1 $2.00 Year 2 $2.20 Year 3 $2.42 Year 4 $2.66 Year 5 $2.93 Year 6 $3.22 Year 7 $3.54 Year 8 $3.90 Year 9 $4.29 Year 10 $4.71
Over a 10-year period the yield on the original $100 investment becomes 4.71% and the total dividends received grow to a healthy $31.87.
The total return, excluding capital gains, would not be extraordinary, but would certainly represent a credible return. A gradually rising dividend stream is, therefore, a valuable aid to an investor concerned with keeping up with inflation.
We can take this a step further by comparing the initial yield with various dividend growth rates. In Table 1-6 we compare the compounding effect of a $10,000 investment in three equities with differing yield and growth characteristics. For the purpose of this example it is assumed that all three companies are growing consistently and are not therefore cyclical in nature. We are also working on the assumption that the stock with the highest yield also has the slowest dividend growth rate and vice versa. This is logical because a company that pays out more in the form of dividends generally has less cash flow for expansion than more miserly dividend payers.
In the example on the left, the company pays out an initial dividend of $400 (i.e., 4% of $10,000) and the dividend is increased at a rate of 5% per annum. The other two companies yield less, 2.5% and 1% respectively, but
Table 1-6 Compounding Effect of Dividend Payouts
Company A Company B Company C
Initial Yield 4% Initial Yield 2.5% Initial Yield 1.0%
Dividend Increases Dividend Increases Dividend Increases Year 5% per Annum 10% per Annum 15% per Annum
1 400 250 100 2 420 275 115 3 441 303 132 4 463 333 152 5 486 366 175 6 511 403 201 7 536 443 231 8 563 487 266 9 591 536 306
10 621 589 352 11 652 648 405 12 684 713 465 13 718 785 535 14 754 853 615 15 792 949 708 16 832 1044 814 17 873 1149 936
grow faster. From a purely income point of view, the first company compares very favorably in the first few years and only falls behind in years 12 and 17, as the higher-growth companies come into their own. In general higher- growing companies will also increase more in value but they will also be much more volatile. This compares to slower–growing, higher-yielding companies, which will be associated with significantly reduced volatility. This investment characteristic will appeal especially to more conservative investors.
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2 The Business Cycle:
Nothing More than a Seasonal Calendar
Why the Business Cycle Repeats A Typical Cycle The Economic Sequence Introducing the Concept of Rate of Change More on the Chronological Sequence of Events Using Indicators to Demonstrate the Sequence
Economic history in the United States goes back basically for 200 years. Dur- ing that time it is possible to observe a consistent fluctuation in the level of
economic activity between growth and contraction. This experience is not limited to the United States but also extends to other countries. Indeed, in Europe the record keeping, though vague, extends back further, but the same repetitive observation holds true. The alternation of growth with contraction is known as the business cycle and it lasts approximately 41-42 months from trough to trough. The cycle is essentially a reflection of psychology, the alternation between caution, optimism, greed, and fear, so there is no reason why it will not continue to operate unless there is a substantial change in human nature. In this chapter we are concerned with the questions of defining the business cycle and examining the way in which it works. Later on we will take a look at its importance for the asset allocation process and how an attempt at understanding the cycle can aid in obtaining superior results.
At this point you may be left with the impression that the business cycle operates on a regular beat and repeats more or less exactly. Unfortunately
23
that is not the case because each cycle has its own characteristics, including duration and magnitude. Remember, the 41-month time span cited earlier is an average, which means that the period between cyclic troughs can fluctuate considerably. There are many reasons why this is so, but I believe they can be narrowed down to two principal ones.
The first is due to the fact that the business cycle, otherwise known as the Kitchin cycle (after its discoverer, Joseph Kitchin) is dominated by far stronger and longer economic cycles, all of which are operating simultaneously. Two of the more dominant are the Juglar, or 10-year cycle and the Kondratieff, or 50- 54 long wave cycle. In his classic book Business Cycles, Joseph Schumpeter iden- tified the three cycles, which he combined into one. Chart 2-1, which Topline Charts kindly allowed us to produce, shows this cycle with key markets from the eighteenth century to around the turn of the millennium. We shall have a lot more to say on the Kondratieff cycle and secular or very long-term trends in Chapter 4. However, for now all we need to know is that the Kondratieff Wave is essentially concerned with inflationary and deflationary forces and that its associated secular trends dominate the characteristics the individual business cycles that form part of it. For example, each business cycle has an inflationary and a deflationary part. If the prevailing secular trend is inflationary, this will mean that the business or Kitchin cycle will experience a longer and more pronounced inflationary phase as well. In effect the bull market in commodities and bond yields associated with the Kitchin cycle will be longer and have greater magnitude when the long wave is experiencing an inflationary trend. The most recent secular or very long-term inflationary trend began in the mid-1930s and lasted through the 1970s. Between 1981 and 2005 the dominant force, as flagged by bond yields was deflationary (i.e., the Kondrati- eff down wave), which has resulted in long Kitchin-associated bull markets in bond prices and relatively short bear markets.
The second principal reason why the characteristics of each business cycle differ lies in the fact that the economy consists of many parts or sectors. These sectors do not rise and fall with equal proportion but differ from cycle to cycle. For instance, there may be a structural reason why the economy needs more housing than normal. Perhaps there has been a shift in demo- graphics where a higher proportion of the populace is in a family formation phase. This will mean that housing will play a more dominant role in the recovery than normal. Usually when a sector experiences above-average performance, businesspeople factor it into their decision making process. As a result, temporary strength is often confused with what may be thought to be the new norm, and businesspeople in the housing sector become unduly optimistic. In turn, this causes them to anticipate greater potential rewards and so become willing to take on additional risk. The promise of easy profits inevitably results in careless decisions and distortions in the industry. In another cycle it could be an excess of consumer debt and a financial imbal- ance in the banking system. Alternatively, a sharper commodity price rise
than normal could encourage businesses to accumulate inventory. That’s fine while sales hold up, but when they decline these “adequate” inventory levels are then perceived as excessive. Whatever the reason, we usually find that one sector of the economy overbuilds or overlends. In this way these sectors increase their representation in terms of economic share on the way up and exaggerate the speed of the decline on the way down.
We can also introduce a third reason that accounts for different business cycle characteristics, and that lies with the fact that the structure of the economy changes with the passage of time. For example, in the nineteenth century the U.S. economy was strongly represented by farmers. Later, manufacturing dominated, and in the latter part of the twentieth century, the service industries came to the fore. Throughout the whole period the role and influence of federal, state, and local governments grew. In the nineteenth century, the big economic number was pig iron. Who follows that series in this, the day of the Internet? The net result is that the economy is now less influenced by cyclic elements than it once was, especially as the role of government and its associated transfer payments have added a layer of stability to the whole thing. That
The Business Cycle: Nothing More than a Seasonal Calendar 25
Chart 2-1 Four Long Waves. (Courtesy Ian Gordon, The Long Wave Analyst, www.thelongwaveanalyst.ca. Statistics prepared by Topline Investment Graphics, www.topline-charts.com. Graph was prepared by Lucidlab, www.lucidlab.com)
is not to say that longer-term imbalances cannot arise, but from the point of view of individual business cycles, volatility appears to be on the downswing.
It is also important to understand that most of the processes involved with the business cycle are cumulative in nature so that once they have gained upward or downward momentum, such trends tend to perpetuate. It takes a long time to slow down and reverse the course of an oil tanker or freight train, and so it is with the economy. One key mistake made by many observers, including this one, is to underestimate the resiliency of these trends. It is amazing that once a recovery gets underway it becomes very resilient to unexpected shocks, whether political, natural, or human made.
Having made a few general observations about fluctuations in business activity, it is now time to return to our main theme, which is asset allocation around the business cycle
In this chapter we are principally concerned with the Kitchin, or four- year cycle. Figure 2-1 shows an idealized cycle, where the sine curve repre- sents the growth path of the economy. The horizontal equilibrium line indicates a period of no growth. When the sine curve is rising above the equilibrium line, it tells us that the economy is growing at a faster pace. When it peaks out and starts to decline the economy is still growing, but at a slower and slower pace. Eventually the line slips below zero, or equilibrium, which means that the economy is shrinking. As long as it is falling below zero, the downside economic momentum is picking up steam. Even- tually the sine curve rises, but because it is below zero, the economy is contracting. However, the pace of decline is slowing. Finally, when it crosses zero, growth becomes positive and a new recovery is underway.
We said earlier that the economy is not homogeneous, but consists of a number of sectors, each of which goes through a series of chronological sequences. How then can we talk about “the economy” as if it is a single unit? The answer is that the theoretical growth path in Figure 2-1 is representative of what we might call the coincident part. For example, the economy also consists of leading and lagging sectors, each simultaneously undergoing their own, but separate, paths of growth and contraction. Our diagram reflects those sectors that are sandwiched between them. If we were to add up all of the sectors––some leading, some in the middle, and some lagging and average them––the curve shown in the diagram would offer a fairly close fit. When we refer to the economy in this and subsequent chapters, we mean the aggregate sum of business activity as reflected in the diagram.
Why the Business Cycle Repeats
The business cycle really consists of a number of economic decisions made by people, either individually or as a group. The alternation between recovery
and recession is a direct function of people responding to positive stimuli (the recovery) and then constantly repeating the same mistakes that cause a recession or slowdown in the growth rate. These decisions are psychologically driven, either in anticipation of future conditions or as a response to existing ones. For example, corporations expand their capacity to produce because they anticipate future growth. On the other hand, workers are often fired in response to declining sales, etc. The key point is that the business cycle develops because human nature is more or less constant. They say that history repeats but never exactly. The same is true of the business cycle. People make the same mistakes, but each time it is different people in different sectors making mistakes of differing degrees. For example, it’s human nature to extrapolate the recent past. If your favorite sports team has been on a win- ning streak, it’s normal to expect them to continue. Similarly, if the economy has been expanding for a year or so, most people will have gotten used to the positive conditions. Because the news background will also be favorable, there are few grounds for expecting economic weakness. If there were, people would take action in anticipation.
In an opposite sense, if business activity has been contracting and your company is really suffering along with others, it is easier to make those cost- cutting decisions. On the other hand, if you are certain that the economy is going to pick up next month, you would perhaps postpone or cancel the
The Business Cycle: Nothing More than a Seasonal Calendar 27
Figure 2-1 Business Cycle Growth Path (Source: pring.com)
cost-cutting exercise. “The regularity is in the pattern of these reactions, not in the cycle itself” is how the late Dr. Richard Coghlan put it in his book Profiting from the Business Cycle (McGraw Hill, London, 1992).
While the explanation here will provide you with a framework from which to allocate your investments around the business cycle, it is not and cannot be an actual map containing pinpoint accuracy. This is because no business cycle pattern is repeated exactly. If it were, the forecasting process would be easy and would most probably be instantly discounted by the markets. Generally speaking, people learn from their own experiences and will not repeat identical errors in successive cycles. For example, you might be a property developer who got caught in the previous downdraft with excess housing inventory, which was eventually sold at a loss. This would have been a painful mistake, and you would certainly take steps to make quite sure to avoid or certainly mitigate such problems in the future. However, not everyone who experiences one business cycle will be around for the next, because there is a constant process of renewal and replacement as new participants emerge and old hands retire from the scene. Also, the degree of distortion for each economic sector differs in each cycle, so even those who remain constant in an industry could quite possibly emerge unscathed and therefore relatively ignorant of firsthand experience of the pitfalls of over- expansion. The longer the time span that develops between these experiences, the greater the potential for distortion. Thus the cloud from the damage of the 1929-32 bear market that hung over market participants for decades after was pretty well forgotten at the time of the peak in the tech bubble in 2000. Each generation has to gain from its own experience. Knowing that someone else went through trials and tribulation may help a bit, but there is nothing like firsthand experience of financial suffering to give a person conservative financial religion.
At the beginning of the cycle, decisions are made cautiously with great thought because the memory or the previous business contraction is quite vivid. The most common mistakes develop at the end of the recovery when things are at their best, overconfidence abounds, and companies plan major expansions. Because everyone else in that particular industry is experiencing the same buoyancy in sales and profits, everyone is in an expansionary mode and that creates a condition of excess capacity. This overbuilding is not obvious at the time because sales are strong and profit margins fat, but when revenue weakens, the excesses become obvious for all to see. At that point workers are laid off and the economy contracts. Such extremes are not confined to the manufacturing and construction industries but can appear in any sector. It never ceases to amaze me that the brokerage industry, which should know better, is often seen moving into plush new offices right at the peak of an equity bull market. The justification for the increased overhead is typically based on the maintenance of an unsustainable level of commissions
28 THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOC

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