Inflation Rears Its Ugly Head

January 25, 2010

Howard Marks is chairman of Oaktree Capital, a large and well-known institutional alternative fixed income manager. Mr. Marks’s memos are always thoughtful and worth reading. This go round he has a discussion of all of the things that could go wrong with the world economy—essentially a list of all of the things that could go wrong. One of the things that could go wrong is inflation.

He believes rates are more likely to go higher than lower, and that inflation, long forgotten as a risk factor, might return. In addition, he has a list of suggestions on how to deal with inflation including TIPs, floating rate debt, gold, real assets like commodities, oil, and real estate, and foreign currencies. His catalog of alternatives is even longer, but you get the idea. (If you want to read the whole memo, you can find it here.)

That’s quite a list, but the first thing that I noticed about it is that not one of these items is generally considered as an investment option by retail investors. Most investors are mentally stuck in the domestic stocks/domestic bonds arena. Diversification consists of hitting more than one Morningstar style box. If inflation does come back, that’s not going to cut it. In fact, Mr. Marks asks investors, “How much of your portfolio are you willing to devote to protect against these macro forces?” He says if the answer is 5%, or 10%, or 15% that those levels are pretty close to doing nothing. He thinks a portfolio will need to devote at least 30-40% of assets toward inflation protection if it recurs.

Investment flexibility and risk diversification were the primary reasons that we launched the Systematic RS Global Macro account as a retail product last year. Many of the inflation hedges in Mr. Marks’ list are asset classes that are available in the Global Macro portfolio, including TIPs, gold, commodities, oil, real estate, and foreign currencies. Given our basket rotation strategy and our adherence to relative strength, the Global Macro portfolio could easily have 40% of its assets, or more, in inflation hedges if inflation were to recur. I think the jury is still out about how the world economy will respond to decreased levels of fiscal stimulus, but it’s good to know that you have options.

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Posted by Mike Moody

Another Worthless Prediction

January 25, 2010

Last week there was a lot of concern about bonds issued by the government of Greece. Prices fell as the government unveiled a plan to reduce debt that observers deemed unlikely to work. This Bloomberg story, Greek Bonds Slide on Concern Investors May Shun New Debt Sales, was pretty typical coverage.

This week the Greek government issued its new debt. Investors Flock to Greek Bond Issue is today’s headline in the Financial Times. Ouch! Apparently investment factors did a 180-degree turn in the last few days.

The fact is that prediction is hazardous and difficult to get right. This type of foiled prediction is a daily occurrence. Trying to make money through predicting what might happen next is just not going to work on a consistent basis. Sure, you might get lucky once or twice, but your odds of getting the next prediction right are probably still a coin flip.

Instead of guessing, why not just look at what is actually happening in the market? That is the approach of our systematic relative strength process. We simply measure the relative performance of different assets and try to keep the portfolio concentrated in the ones that are strongest. No prediction is required—and we like it that way.

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Posted by Mike Moody

Weekly RS Recap

January 25, 2010

The table below shows the performance of a universe of mid and large cap U.S. equities, broken down by relative strength decile and quartile and then compared to the universe return. Those at the top of the ranks are those stocks which have the best intermediate-term relative strength. Relative strength strategies buy securities that have strong intermediate-term relative strength and hold them as long as they remain strong.

Last week’s performance (1/18/10 – 1/22/10) is as follows:

Tough week for the broad market, and tougher week for high relative strength stocks last week.

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Posted by Andy Hyer

A Valuation Case for Emerging Markets

January 25, 2010

We don’t pay attention to valuation, but fundamental analysts who do apparently still have no problem making a case for emerging markets. The graphic below is from Bespoke Investments. They’ve taken the concept of the PEG ratio (price-to-earnings ratio divided by earnings growth rate) and applied it to broad economies. In this case, they’ve taken the broad market PE ratio and divided it by the country’s GDP growth rate. The countries are then ranked from cheapest to most expensive.

At the cheap end are the big emerging markets of India, China, and Brazil. At the most expensive end are the overly indebted European countries like the U.K. and Spain. Perhaps not surprisingly, that’s how relative strength has them sorted out at the moment also.

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Posted by Mike Moody