Thursday, July 29, 2010

Unusually Uncertain

Last week in his testimony before the House Banking Committee, Federal Reserve Chairman Ben Bernanke testified that the economic outlook was “unusually uncertain.” Bernanke’s comment raises the question of what is the “usual” level of economic uncertainty. For example, in the days leading up to the financial catastrophe that struck Wall Street due to the mismanagement of subprime mortgages and related derivative products (among a host of other things), our Fed Chairman told us that the risks of subprime mortgage products were “contained.” I wonder what level of certainty he had when he told the nation about that particular forecast. It might have been helpful if he would have added that his view about subprime was “unusually uncertain.” The whole idea of certainty when it comes to active management of portfolios, or monetary policy if you are a Fed Chairman is something that I have often written about.

Pinnacle “grades” our investment forecasts from being high conviction forecasts to low conviction forecasts, which means we look at the world with varying degrees of uncertainty. I think there is a noticeable difference between our viewpoint, which is based on degrees of uncertainty, and an approach that is based on certainty. For us the financial landscape is always uncertain, and never certain. I believe that those who are certain of their investment conclusions are social misfits, idiot savants, or in most cases, just delusional to one degree or another. When we have the most conviction in our forecasts, meaning we are more certain of our outlook in an uncertain world, we are more likely to change the asset allocation of our portfolios to express whatever investment view we have at the time. We use our risk benchmarks as “home base” when evaluating portfolio construction and are likely to make bigger bets versus the risk benchmark. When we are feeling “unusually uncertain” about our forecast we are more likely to manage portfolio risk around the levels of volatility that our clients have already agreed to. In more practical terms, Pinnacle asset allocations will not get to 100% cash or 100% stocks, unless we arrive at such a high level of conviction in our forecast that we are certain of future market direction. It ain’t gonna happen.

I think the financial markets have been unusually uncertain ever since the bear market that ended in March of 2009. While we have enjoyed a cyclical bull market from the market lows of 666 to today’s S&P price of around 1100, I believe that economic and market forces have made it difficult to invest the bull or bear case with any kind of conviction for the past 16 months. Lately the “flash crash” and the European sovereign debt crisis have reminded investors that system risk in the financial markets remains high, and investors should invest with care. At the moment we have a relatively high conviction that we don’t want to be overexposed to risk in Pinnacle portfolios as we finish the summer and enter the historically volatile months of September and October. In the meantime, I appreciate Chairman Bernanke’s comments. Of course, our market outlook for the fall could change based on changes we see in the data. I suppose that means that our forecast is “usually uncertain.”