Systematic Relative Strength

It’s well known in psychology that one-trial learning can be created if the stimulus is aversive enough. For example, a child that puts down their hand on a hot stove typically will never do it again. Maybe that is part of what is happening with the stock market right now.

According to a recent article in the New York Times, investors are acting differently toward the stock market recovery this time around.

After past recessions, ordinary investors have typically regained their enthusiasm for stocks, hoping to profit as the economy recovered. This time, even as corporate earnings have improved, Americans have become more guarded with their investments.

“At this stage in the economic cycle, $10 to $20 billion would normally be flowing into domestic equity funds” rather than the billions that are flowing out, said Brian K. Reid, chief economist of the investment institute. He added, “This is very unusual.”

Investors have been buying so many bonds that there has been unrelenting talk about a “bond bubble.” I’m not sure that investors are actually interested in bonds; I think the emotional drivers may be more complicated.

Surveys over the years have shown that most retail investors do not even understand that bond prices and interest rates are inversely related. It’s not unusual to find an investor that thinks the U.S. is headed for inflation down the road, but is still happily buying bonds right now. Maybe I am incorrect in my assumption, but I don’t think the average person managing their own 401k plan is paying close attention to all of the economic arguments about the prospects for inflation or deflation. They just aren’t that sophisticated. I think they are buying bonds because 1) they got burned in stocks and want out, and 2) bonds are pretty much the only other investment option they know about.

In other words, it may be that investors are simply removing their hand from the stove (stocks). Because their knowledge about financial instruments is so limited, however, there is a potential danger of going from the frying pan to the fire.

Bonds are simply loans. If all goes well, you get your money back with interest. Bonds might hold their market value in a deflationary or slow growth environment, although a slow economy might actually increase the chances of default. Bonds are not growth instruments.

All great fortunes, on the other hand, depend on growth. Entreprenuers that start a company that grows sometimes become wealthy. Real estate fortunes are made using leverage—and growth in the underlying property values or their cash flows. Stock market fortunes have been made through canny ownership of equity securities. Off the top of my head, I can’t think of any fortunes that have depended on buying loans.

In their rush to run away from pain, many investors have, perhaps unwittingly, also run away from growth. Believe me, I understand the appeal of bonds right now. Every investor has taken plenty of lumps over the past few years. Yet the only way I see for investors to successfully prepare for retirement involves exposing a significant part of the portfolio to growth.

There are a couple of ways to accomplish that. One could construct a strategic allocation with some growth exposure, or you could look to a tactical portfolio that owned growth investments when equity market conditions were strong and owned other assets when equity market conditions were not conducive. Such a portfolio need not be limited to stocks and bonds; it could include other asset classes such as commodities, currencies, and real estate. This flexibility in tactical asset allocation was the driving idea behind our Global Macro portfolio. A portfolio that rotates systematically toward strong asset classes has the ability to profit during strong trends and the potential to reduce capital risk in poor equity environments. To our way of thinking, a flexible solution is superior to a knee-jerk reaction to exit all growth investments.