Monday, May 4, 2009

Low Conviction Forecasts

There seems to be a misunderstanding about generating an investment forecast that presumes that active portfolio managers always have a reliable one in their back pocket. Nothing could be further from the truth. Sometimes the forecast is as simple as “I don’t have a strong opinion one way or the other.” Such a forecast actually happens more often than not, and shouldn’t be a cause for alarm for investors. After all, forecasting is all about assessing future probabilities, and sometimes the data simply doesn’t allow for making a high probability forecast.

I believe that now is one of those times. Those that believe that they “know” what the outcome of the current state of economic affairs will be are making a high conviction forecast based on an unprecedented set of economic circumstances. There is nothing new about a country debasing its currency, and there is similarly nothing new about trying to inflate assets in order to prevent a debt liquidation and deflation. But it is certainly new to do so in an economy as deep and diversified as the U.S. economy, and to do so in such a coordinated manner within the global economy. By our count we are now up to about $12 trillion of guarantees and promises to invest by the various agencies of the U.S. government, and that is in the context of a $14 trillion economy. Who can “know” where this will lead?

Low conviction forecasts are not a problem for us as a relative value manager. In this case we get more, rather than less, diversified. In addition, we manage portfolio risk to be closer to our client’s risk benchmarks, as opposed to making large bets one way or the other. Our assessment of whether or not this latest 30% rally off of the intraday low of 666 for the S&P 500 Index represents the beginning of the next cyclical bull is inconclusive. At the moment I would characterize the situation as a coin flip either way, and in that situation we will hug our benchmarks, more or less. However, there is no doubt that the entire investment team would be more comfortable if the market would back and fill a little, and give us the opportunity to add to risk positions after a meaningful retracement of recent gains.