Friday, October 28, 2011

The Wrong Tail of the Curve

Let me be clear: Pinnacle’s investment mandate is to outperform over a complete market cycle, and that definitely includes outperforming in bull markets. Lately, however, the bull markets have been built on the back of extreme monetary and fiscal policy. It was just about this time last year that Pinnacle’s investment team found themselves on the wrong side of a rampaging bull market. The summer’s headlines about Greece and the frightening after-shock of the “flash crash” were receding in everyone’s memory and investors were beginning to anticipate a massive policy response. We were suspicious of the fundamentals of the market at the time, but our process forces us back into the market when technical considerations become overwhelmingly bullish, and so we looked for a place to enter. The market finally cracked in November to the tune of a 3% “correction” and we began adding risk back into the portfolio. The best I could say is that we were, at best, cautiously bullish. Well… it feels to me like history is repeating itself this year, with the same kind of rally coming off of a similar summer selloff, with the same type of hype regarding policy response that just doesn’t feel right. Once again we are trying to guide our clients through incredibly volatile markets that feel more like casinos than rational markets where participants try to allocate capital to profitable ventures in order to grow their wealth.

The problem is that we live in a world of asynchronous risks, meaning that the systematic risks in the world’s economy are so great that if the wheels come off the cart, the result will be catastrophic to our clients' financial plans. We have seen two frightening bear markets in the past decade when investment bubbles that were, in large part, the creation of policy makers, burst. I have often said that in the current environment, our job is to buy into bubbles and then sell them before they burst. (Actually I’m not so greedy that I wouldn’t be happy with selling just after they burst.) The problem with the “buy the bubble” plan is that if you know the bubble is a bubble, then buying into it becomes an act of pure speculation. And we are not in the business of speculating with our clients' money.

So here we go again. The market is running away on the strength of what, at first glance, seems to be a poorly-defined agreement in Europe about what to do with a solvency crisis that can’t be resolved by leveraging up rescue capital to the tune of 5:1. In addition, recent U.S. economic data includes some prints that contain the somewhat lukewarm good news that we are not currently in a recession, even though the real economy still seems extraordinarily fragile. At some point additional evidence of improvement may compel us (Pinnacle) to buy, because at the end of the day you have to respect the market, and sometimes it does irrational things for very long periods of time. When systematic risk is as high as it is today, investment professionals mutter about “tail risks,” or the risks that are measured at the far left of a normal probability distribution. At the moment, it seems to me that if things don’t go exactly right there are large potential losses to be defended against. We are bound to respect these risks for our clients, but lately it feels like we are worried about the wrong tail of the curve.