Monday, July 20, 2009

The Oh-So-Sweet Sleep of the Certain

Recently I had the opportunity to review the investment results of two different money managers who had correctly called the market top in 2007 and by January of 2008 had safely invested 100% of their investment capital in cash. The resulting investment results are, as you can imagine, spectacular. Both firms are quantitative in nature, meaning that they use proprietary technical-analysis-based methods to determine market trends in order to make their investment calls. In one case, the manager has a trade-marked trend identification system that protects their clients from downturns. While I tip my hat to these managers, I continue to view any portfolio construction that is either all-in in terms of stocks and risk assets, or all-out in terms of cash, as a somewhat high risk proposition.

To me, going 100% to cash screams that the investor has 100% conviction that his or her forecast is correct. I just don’t know how anyone can get to that level of certainty. I’ve often said that they must sleep the sweet sleep of the certain, with no doubts about their forecast, their trading system, their proprietary models, their decision making process, and the well documented irrationality of their fellow investors. I’m envious. When Pinnacle portfolios are positioned to be widely divergent with our benchmarks, as they were in January 2008 with our correct bear market forecast, I don’t sleep well at all. Experience has taught me that financial markets are notoriously fickle, and that making large bets about market direction…either direction….takes a certain amount of courage, or a certain amount of hubris. I suppose it is fair to say that we (Pinnacle) are either very wise in recognizing that the irrationality of markets should be approached with the greatest of respect, or we simply lack the courage of our convictions. I believe that the correct assessment is the former.

From a portfolio construction point of view, it turns out that being fully invested in risk assets still allows a portfolio manager a great deal of latitude to “hide in the market” and still manage risk. Being 100% in U.S. stocks but owning staples, health care, and utilities is likely to result in capturing 50% of the market’s volatility in a bear market. If the market rallies and you were wrong in your short-term assessment of market direction, you will still crush cash returns to the upside. On the other hand, going 100% to cash, when cash pays 1%, is truly a high risk proposition from the standpoint of generating total returns. There is no “repair strategy” from there that I’m aware of. Investors must be 100% certain that the market is not about to rally. For our part, we prefer to actively manage portfolios where our equity exposure varies with our forecasts but we don’t end up at either extreme of market timing. It allows us to sleep the oh-so-sweet sleep of the uncertain!