The way you prevent Ponzi schemes is by requiring that assets are audited based on their tradable market value, and that the auditors make certain those assets are actually in custody. Unfortunately, banks are now allowed to value many of their assets with substantial discretion, and the models may be no better than the ones that assigned investment-grade ratings to sub-prime loans. Meanwhile, numerous banks have been abruptly suspending foreclosures, because it is increasingly evident that in many cases they do not even have documentation of the underlying mortgages. It is difficult to see how this can possibly inspire confidence that the credit crisis is over and everything is back to normal.
To be clear, I should emphasize that our expectation for poor equity returns over the coming 5-7 years is driven by valuations, not by any particular expectation regarding credit strains or economic pressures. The importance of the economic factors is that they threaten to front-load the longer-term reversion of valuations into the immediate future.
A 5-year return of zero, for example, can be achieved by 5 consecutive returns of zero, or by a 32% decline in a single year followed by four consecutive years with positive returns of 10% each. The argument is not that stocks will perform poorly on a consistent basis for the next 5-7 years. Frankly, I would much prefer a retreat in valuations sooner than later, and with sufficient force to dissuade investors from returning to the unproductive, economy-wrecking, bubble-chasing mentality that has ultimately sabotaged their long-term financial security. In any event, 5-7 years from now, when investors look back at today's investment opportunities, they are unlikely to view them longingly.
Market Climate
As of last week, the Market Climate in stocks was characterized by strenuous overvaluation, overbought, overbullish conditions, and unfavorable economic pressures. This is a combination that has historically been associated with poor returns, on average. As always, our interest is on the average return/risk tradeoff associated with the conditions we observe. For now, we remain defensive. In the Strategic Growth Fund, we remain fully hedged, with a "staggered strike" position where we have raised our put option strikes closer to market levels to defend as strongly as possible against potential market losses. In the Strategic International Equity Fund, the majority of our stock holdings are also hedged with a combination of global indices that are well-correlated with our holdings, including the Dow Jones EuroStoxx Index, the FTSE 100 and the S&P 500. To the extent that we use international stock indices to hedge, those indices hedge both the equity risk and the currency fluctuations. Meanwhile, using the S&P 500 as a hedge covers broad equity risk while leaving some of our currency exposure unhedged, which is intentional.
Last week was a bit uncomfortable for Strategic Growth, as the "risk trade" on hopes about quantitative easing strongly favored aggressive stocks over conservative ones, so our holdings did not participate well in the advance. This happens from time to time. We just stick to our stock selection discipline, which has served us well over the years.
While the S&P 500 has essentially gone nowhere since early January, the present overvalued, overbought and overbullish conditions, coupled with still negative economic pressures, suggests the potential for a familiar pattern of market behavior that I refer to as "unpleasant skew." The short-term tendency in such conditions tends toward small advances to repeated marginal new highs, often followed abruptly by a steep "air pocket" that wipes out weeks or months of progress in the span of a few days. During the interim, however, it's typical for 2-3 day pullbacks to to be followed by spike advances that do little but recover the lost ground, but that make the advance appear relentless. The average of numerous modest gains and a smaller number of steep losses may be negative, and yet, from a frequency perspective, there can be more up-days than down-days. Suffice it to say that we view the prospective return/risk profile of the market here as poor, but that assessment is based on average behavior.
In bonds, the Market Climate last week was characterized by moderately unfavorable yield levels and favorable yield pressures. The Strategic Total Return Fund continues to carry a duration of slightly over 4 years. On significant strength in precious metals and foreign currencies (neatly following the "exchange rate overshooting" argument that I discussed a couple of months ago), we did clip our holdings back, now with about 6% of assets in precious metals shares, about 2% of assets in foreign currencies, and about 2% in utility shares. My impression is not that the weakness in the dollar has fully run its course, but quantitative easing was elevated last week to a near certainty in the minds of investors. My impression is that it is not as certain as investors appear to believe, nor would it have the straightforward benefits that investors seem to assume. More on that next week. For our part, last week's strength was a good enough opportunity to take a bird in the hand on part of our holdings.
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