Fear the Ostrich

Yesterday, we received an email that basically said that market emotions were running wild, and that those who just held during this period would be rewarded. It sounded pretty 'Buy and Hold' to me, and one of our wealth managers suggested we write a refutation.

Here were my key points to rebut the idea that inaction is the best approach in all market environments:

• Most Advisors ignore the business cycle that clearly exists and that has an effect on asset prices.
• Most Advisors think technical analysis is akin to voodoo.
• Most Advisors are willing to invest your money but not willing to invest their time or money on an investment team.
• Most Advisors realize that buy and hold is a much better business strategy than investing strategy.
• Most Advisors would rather hope that markets get their clients to retirement than actually work on a strategy to get them there.
• Most Advisors are like ostriches, putting their heads in the sand and betting that 'Buy and Hold' will continue to work.

Luckily, we at Pinnacle aren’t most advisors.

If you're currently working with a 'Buy and Hold' advisor, then you’d better hope we're wrong in our assessment that there's a high probability we're in a persistent bear market. In a bull market, a rising tide lifts all boats, but as legendary investor Warren Buffet once said, “It’s only when the tide goes out that you learn who was swimming naked.”

Fear the ostrich.

Asking the Wrong Question

In academic terms, or in terms of the Capital Asset Pricing Model, known as CAPM, the risk of owning the market is called systematic risk. Nowadays, as one financial institution after the other seems in danger of collapsing, we hear much about systematic risk. Nevertheless, for professionals who try to manage risk in portfolio construction, it seems like a good trade-off -- business risk for market risk. As a result, portfolios are diversified by asset class, where each asset class is owned as a diversified portfolio of securities designed to eliminate the business risk of owning individual companies. The goal is to only capture market risk and returns. Of course, informed investors must then choose how to do so. They can buy an index fund to capture the risk and return of the asset class (by actually owning the market), or they can hire a money manager who is constrained to actively manage securities in the asset class the investor wants to own. Investors use mutual funds, wrap-accounts, limited partnerships, and other investment companies to hire money managers. It really doesn’t matter what the structure is -- we know from dozens of studies that, on average, if the active money manager is constrained by investment style and is only allowed to own securities in one market as defined by one asset class benchmark, the results are going to be very close to owning the index or market.

This question -- whether to own the market risk and return by owning an index fund or to hire a money manager and try to "beat the market" -- is what everyone means when they talk about active management. That's a shame, because we’ve known for more than a decade that everyone is asking the wrong question. The correct question is, if we have traded off business risk for market risk, then what is the “real-world,” practical risk of owning the market? Traditional thinking says there is little danger to owning markets, so long as you hold them long enough. In the short-term everyone agrees that no one can forecast the returns of markets, but in the long-term, market returns are expected to regress to their long-term mean (or average) return. In terms of asset allocation, 'buy and hold' means to own an asset class long enough for it to earn its long-term average return, and presumably do so with long-term average risk or volatility. The problem, as most everyone is now learning, is that risk markets have not reliably earned their long-term average returns for more than a decade, putting many financial plans -- not to mention pension plans -- at risk.

So what’s to be done?

Wall Street concocted a strategy that included another trade-off. Exchange the risk of markets for the risk of financial strategies that deliver returns that are not correlated to the markets. These new strategies, run by managers who are presumably smarter than the average style-constrained money manager, include private equity funds and hedge funds that are the darlings of institutional investors everywhere. Market-neutral, long-short, event driven, convertible arbitrage, global macro... the list goes on. All are designed to solve the problem of markets that are misbehaving, and can presumably generate positive returns when markets do not. Unfortunately, the uncorrelated strategy solution has its own problem: These strategies only work some of the time, and there is so much money chasing them that the returns are being arbitraged away.

It turns out that accepting business risk, market risk, and low correlation-strategy risk, all have their unique problems. Pinnacle’s solution to the problem is unique. Stay tuned for that.

More Confusion about Buy and Hold Investing

I watched with a mixture of horror and amusement the other day as Tyler Mathisen, guest host on CNBC’s Squawk Box, introduced a segment with Ron Baron, an iconic value manager, by saying that Baron claimed that “buy and hold is alive and well.” As regular readers of this blog know, as the author of a book called, “Buy and Hold is Dead (AGAIN)”, I try to keep readers abreast of the latest misrepresentations and misinterpretations about the subject in the media and elsewhere. This latest nonsense comes under the category entitled, “value money managers whose definition of buy and hold has nothing to do with modern portfolio theory and is the absolute opposite of the ‘buy and hold’ message taught to investors by the media and the majority of investment advisors.”

Let’s review. Value managers begin the investment process with the somewhat conceited idea that they can better value individual securities than “the market.” Since the market is made up of literally millions of investors, the notion that any one investor has a better understanding of the true value of a security than the masses of investors who set the price on a daily basis seems unlikely. Yet, since Graham and Dodd published their book, Security Analysis, back in the mid 1930’s, where they explain how to analyze a company’s balance sheet and profit and loss statement in order to determine the fair value of a company’s stock, the best value investors have attempted to beat the market. Anyone who knows the investment business knows that Ron Baron is a long-time, ultra-successful, traditional value investor who tries to buy company shares at a discount to their fair value. For investors like Baron, or the most well-known value investor, Warren Buffet, the investment time horizon that they operate in is very long-term. Baron does not mind that it may take years for the rest of the market to discover the value of the securities he discovered through his own research. He believes the market will ultimately bid the price of his shares to their fair value, and when it does he will earn a profit. Therefore, the only context that Ron Baron believes in buy and hold is to say that he is willing to own discounted shares for as long as he needs to for the market to discover the true value of the business franchise that he owns.

In the world of strategic asset allocation, or the buy and hold investing that I refer to in my book, there is no such thing as an individual investor finding a discounted security. In the fairy tale world of buy and hold, securities are considered to always be fairly priced due to an absurd notion called The Efficient Market Hypothesis. Because markets are always deemed to be fairly valued, there are no values to be found, and so investors should simply buy and hold securities in order to earn whatever returns the market will give them. In this context for buy and hold, investors are expected to believe that the historical average returns of markets are theirs for the taking, if they are only patient enough. Clearly, patience has not proven to be a very good investment strategy since the dot-com bubble burst in March of 2000. To put Ron Baron on the air as a spokesperson for buy and hold investing reflects a fundamental misunderstanding of what he does for a living and insults his reputation as a truly outstanding value investor. It is also an example of how the investment industry and the media crush individual investors with terrible investment advice. Baron, and Buffett, would throw-up at the notion that markets are always efficiently priced and that investors can earn historical average returns regardless of the price that they pay for a security. They are perfectly happy to buy and hold their discounted shares and wait for the rest of us to figure out what they already know about the fair value of the stocks in their portfolio.

“You’re a Market Timer…No I’m Not…Yes You Are”

Me: Market timing is nothing to be ashamed of. Every active manager who does something other than buy and hold securities is inevitably involved in some sort of market timing.

Them: Nonsense. Market timers try to predict the future and I would never do that.

Me: Really? What motivates you to change the securities in your portfolio?

Them: I study 75 different indicators to see what they tell us about past market behavior. Then I look for anomalies in the current data that might indicate a high probability of a certain market event. Then I use great discipline in executing changes based on high or low probability events without predicting the future at all….I just rely on my indicators to tell me what to do…and I do it.

Me: So what if your indicators tell you to sell stocks and you go ahead and sell them. Doesn’t that imply a forecast by you that stocks have a high probability of falling in value in the near future?

Them: No, I’m not making a prediction. This is just a high probability based on my scientific and systematic application of my trading system.

Me: But if you are selling and you don’t know the future, then the application of your trading system, which results in a buy or a sell, is the result of a forecast about future market direction.

Them: It most certainly is not.

Me: It is.

Them: It isn’t!

Me: The timing of your transaction, which is based on your systematic approach to developing your forecast, results in you timing the market. You can be early, late, or get it exactly right, but you can’t know the future with certainty so you are a market timer.

Them: No I’m not. Don’t call me a market timer. Instead, call me a (fill in the blank).

Me: Oh brother…look…you can be a (fill in the blank), but why won’t you admit that buying and selling securities constitutes an implied forecast of market direction and executing the transaction involves market timing? What is the big deal?

Them: The big deal is...and I’ll say this for the last time…I don’t make market forecasts and I’m not a market timer. I’m a (fill in the blank). End of story!

Me: But the result of applying your strategy can be an extreme asset allocation that represents an “all in” bet in either risk or non-risk assets. If you get the timing wrong that represents a risk to portfolio returns.

Them: So what…I’m systematically applying a strategy to manage risk and it has nothing to do with market timing.

Me: But if you are “all-in” or “all-out” that’s market timing, isn’t it?

Them: No

Me: (sigh)

This May Take Longer than I Thought

In my book, Buy and Hold is Dead (AGAIN), the Case for Active Portfolio Management in Dangerous Markets, I make some intrepid forecasts about the future of the investment industry regarding active or tactical asset allocation. One of my forecasts was that consumers would demand active management as traditional buy and hold, strategic asset allocation strategies failed to deliver expected returns in an ongoing secular bear market. I felt that consumers would demand that the industry change, and that the obvious flaws in the theoretical rationale for buy and hold investing would compel professional advisors to consider a major change in how they approached portfolio construction. Well…perhaps this is going to take a little longer than I thought.

As I was reading the Washington Post Business Section last weekend I came across an article from Kiplinger Personal Finance called, “Knowing financial advisor’s motives, expertise can pay dividends.” The writer, Bob Frick, a senior editor for Kiplinger, did a fine job of discussing the importance of knowing an advisors goals, fees, holistic approach, etc. However, one question he wants prospective clients to ask is, “Do you time the market?” He goes on to say, “By asking an advisor about her investment strategy and how it changes with developments in the markets, you’ll discover whether she’s a closet market timer. Watch out for an adviser who says, for example, that she thought foreign stocks were getting pricey so she shifted client’s money from overseas shares to commodities.”

I love Bob, and anyone else married to the same old tired assumptions about market timing. For the record, there is no more professional and risk reducing strategy that I can think of than to sell overpriced securities in favor of, presumably, more rationally valued asset classes. In this case, holding on to “pricey” foreign stocks is virtually guaranteed to generate less than expected returns for the asset class in the future. A better question for prospective clients to ask is, “how do you determine if an asset class is overvalued and what do you do about it terms of portfolio construction?” Unfortunately, in order for the question to be asked, the financial media has to stop promoting this drivel about market timing. While it’s clear to me from speaking around the country that the professional investment industry is getting very interested in how and why they should actively manage the asset classes in their client portfolios, I think the press is still stuck in the dark ages. That’s too bad for the average consumer, and too bad for financial advisors who are waiting for their clients to revolt before they make the change from passive to active asset allocation.

A New Term to Consider: Asset Allocators

Recently I found myself under deadline to complete an article that should be published in the May edition of Financial Planning Magazine. The article summarizes one of my favorite topics when speaking to audiences, which is to rebut what I consider to be the three main objections to active management. For the record, they are 1) you believe in the Nobel Prize winning theory supporting buy and hold investing, 2) you don’t believe active managers can outperform passive benchmarks, and 3) you think the active management business model is impractical. In the piece I refer to the confusion that reigns in and out of the industry regarding the roles of different kinds of investors. I routinely refer to the two camps as portfolio managers and money managers.

I define portfolio managers as the group of investors who can invest in any asset class with the only constraint being the investment policy of the investor. Portfolio managers are free to own any asset class. Portfolio managers do not have an easy to identify benchmark. On the other hand, money managers are typically constrained by prospectus to invest in only one asset class and one investment style. We know them as mutual fund managers, separate account managers, or nowadays, even hedge fund managers. Money managers specialize in investing in only one asset class, and they typically manage portfolios that own individual securities, rather than pooled investments, in pursuit of beating their easy to identify passive benchmark.

Rick Vollaro, my partner and co-portfolio manager helped to edit my article, and suggested that using the terms portfolio manager and money manager only adds to the confusion. He suggested the term asset allocators instead of portfolio managers. The more I think of it the more I think that Rick’s idea has merit. In fact, any investor who is free to own multiple asset classes without constraint is an asset allocator. The term easily differentiates us from money managers, who are not free to use asset allocation. From now on I think we should compare the roles of asset allocators and money managers. The same conclusion will be reached, which is that the public and the industry is completely confused about the roles that these investors play. The choice of whether you hire “active” versus “passive” money managers has nothing to do with the decision to actively manage your asset allocation. If you don’t manage a mutual fund or a separate account, in all probability you are an asset allocator.

Say It Ain’t So, Gus

Occasionally an article will come across my desk and something in it will catch my attention. This week, William Bissett, a wealth manager here at Pinnacle, dropped me an article published in the Morningstar Advisor called, “Asset Allocation Heavyweights Square Off.” The piece, written by Ryan Leggio in the Feb/March 2010 issue, featured a conversation between John Hussman, the manager of the Hussman Strategic Growth Fund (owned by Pinnacle in our managed accounts) and Gus Sauter, the Chief Investment Officer of the Vanguard Group, the famous money management firm overseeing more than $1.4 trillion of managed assets in over 100 mutual funds. Let me just say that John Hussman, in my opinion, has to be one of the smartest people on the planet and his weekly letter about his fund is required reading for Pinnacle analysts. I most definitely would not want to be on the other side of the table debating just about anything with John Hussman.

Towards the end of an interesting interview, Leggio asked both participants how they feel about relative valuations right now. Here is what Sauter had to say:

“A lot of people have asked, what is the equity risk premium looking forward? Is it zero? Is it negative Is it small? Or is it the historic norm, with the historic norm being in the 5.5% to 6% range? I would say that, on average, the equity risk premium is at historic norms all the time. So, I think that we’re looking at average rates of return going forward, and that’s based on the concept that we’re rewarded for investing in stocks because of the inherent risk of investing in stocks. If we weren’t going to be rewarded for that, we’d sell stocks, and we’d sell them down to a price that made them attractive again. In fact, that’s what happened from the end of 2007 to the beginning of 2009.”

Mr. Sauter goes on to argue that the stock market is priced to deliver historically average returns going forward over the next decade. I don’t know how he gets there from here. Based on normalized P/E ratios the stock market is expensive. Hussman says we will basically get the earnings growth rate from stocks over the next decade, which is about 6%. Many other analysts think we will get a lot less. What is blatantly and obviously true is that the rewards for owning stocks depends on the price at which you buy them, and the average risk premium is a useless bit of information used to confuse buy and hold investors. Gus should forget the garbage about “average risk premiums at historic norms” and get in the game. Investors praying for average returns should know that there is little data to support the idea that buying and holding from these prices will be a successful strategy.

Happy Anniversary

I hate when I forget an anniversary or a birthday, which is why my wife, Linda, took over the job of remembering family dates for birthdays, anniversaries and the like twenty years ago. But I didn’t need any help remembering that this month is the Big One for investors and financial planners. March happens to be the ten-year anniversary of the current secular bear market which has defined the entire career of young planners and investment advisors and severely altered wealth creation plans for just about everyone else.

In March of 2000 the stock market had just finished one of the best five years of annualized performance in stock market history and investors were so enthusiastic that they were paying more than 50-times 10-year normalized earnings to own broad market indexes like the S&P 500. At the time, we left traditional measures of value based on earnings behind, instead measuring the future prospects of American companies by new metrics, like how many eyeballs might view a website. Everyone was getting rich investing in “dot-coms” and the technology sector had grown to be more than 40% of the total stock market by market capitalization. Value investors were in full retreat, or were going out of business, and if you didn’t own the top 50 companies in the S&P 500 you were guaranteed another losing year relative to the broad market. Wasn’t it grand!

Ten years later the stock market is trading 30% below March 2000 prices, and adjusted for dividends stocks have lost about 1.5% per year, before adjusting for inflation. Unfortunately there is no data that I’m aware of to suggest that the stock market will deliver historical average expected returns from current elevated valuation levels. If you don’t care to look at values, perhaps the “new normal” of bloated debt levels, higher consumer saving, more regulation, and higher taxes will convince you that future stock market returns are certainly not guaranteed from here. The only answer will be active management, however you define it. Those who can scrape a few extra percent of returns above what the market will offer will truly be delivering an important service to investors who need to earn risk premiums even though the broad market is not cooperating. Buying and holding from here is truly a high-risk strategy.

Year-end Thoughts on Correlation

I suppose I’m one of the most vocal critics of Modern Portfolio Theory (MPT), the body of academic work that lays the theoretical groundwork for today’s status quo method of portfolio construction, otherwise known as Strategic Asset Allocation. MPT is based on Harry Markowitz’s Nobel Prize winning paper, Portfolio Selection, in which he shows us how to craft “efficient portfolios” with the best or optimal mix of asset classes to earn the highest returns with the lowest amount of risk. I believe the investment industry has distorted Markowitz’s work over the years and the practical application of how it is used in portfolio construction is a scandal.

The secret sauce of Markowitz’s MPT formula is that by combining the correlation of returns with the standard deviation of returns, otherwise known as how asset class returns zig and zag with each other as well as how much asset class returns zig and zag by themselves, you can increase the returns of the portfolio at the same time that you reduce the risk of the portfolio. Of course, this all depends on a good forecast of zigging and zagging. As we close the books on 2009 Pinnacle investment performance, I’m struck by how Pinnacle analysts are forced to deal with MPT in the real, practical playing field of trying to deliver benchmark-beating performance. Because stocks and bonds are the only two asset classes in our benchmark, and because the S&P 500 Index (our stock proxy) is having an excellent year, we are forced to balance two important goals. One is to remain diversified in our portfolio construction as a matter of good risk management, and the other is to have enough risk or “juice” in the portfolio to outperform the S&P as our risk proxy in a bull market.

The problem, of course, is that the two goals can be mutually exclusive in the short-term. If we succeed in providing effective diversification, then the high octane securities we own to beat the S&P may zig and zag at precisely the wrong time, creating a situation where the portfolio has less volatility overall, but delivers lower performance…in the short-term. As we watch the performance of commodities, gold, the dollar, and international stock positions as we approach year-end, we only know that they are volatile enough by themselves to outperform the stock market. We can’t know if they will move up or down on the same days as the U.S. stock market, an unfortunate state of affairs if we are only focused on relative returns. At worst, we should end the year with about the same returns as our benchmarks but we will have done so with significantly less portfolio volatility.

Why? Because.

Over the weekend I was reminiscing about a college professor, Dr. Hill, who actually asked the all-feared question on our philosophy final – “Why?” Being angered at the time at the stupidity of this question I wrote “Because” and walked out of the classroom. I later came to learn that anyone who actually attempted to answer the question got a “C” on the exam. The answer “Why not?” earned a “B,” and my well considered “Because” earned me an “A” on the final. I’ve been thinking about that answer lately because in the investment business, it’s important to know what investors believe in answering the question “Why?”

In the early 20th century, the French mathematician, Bachelier, gave us the first quantitative model for pricing options that relied on the idea that since it is impossible to figure out why prices move in a mathematical formula, it’s best to assume that price changes each day are the same as flipping a coin. He used the mathematics of his day for price movements (Brownian motion) and for volatility (standard deviation) to derive a formula for option pricing that looks very similar to the Black Scholes option pricing model used today. Using the mathematics of probability and statistics to make assumptions about the probability of price changes has been the rule for academics ever since. Markowitz’s Modern Portfolio Theory relies on the same assumptions and the same math to give us the notion of efficient portfolios. For academics, the answer to “Why?” would be to say, “Wrong question.” Modern Portfolio Theorists assume we can’t know “why,” and so they use past data to make inferences about future returns – a process called the stochastic method in science.

For active portfolio managers and value investors of every stripe the answer to “Why?” probably falls into one of two categories. If the answer has anything to do with interest rates, fiscal and monetary policy, earnings, currency, geopolitical news, etc, then we would consider these investors to be traditional value investors who find the answer to the question “Why?” in these and many other well known metrics of economic and financial health. If the answer to “Why?” is determined by the study of market prices, then we would characterize these investors as technical investors. At Pinnacle we expend enormous effort to find both traditional and technical answers to the question of why prices move. The academic approach is misused, misunderstood, and frankly dangerous for investors who think that the answer to “Why?” can be found in past data without understanding the “because.” I agree that actually finding the one reason that prices move is an impossible objective. But ignoring the news and the behavior of investors can only make you money in a long-term bull market, a state of affairs that may not be in the cards for quite awhile.

We Don’t Sell Performance Here

Pinnacle Advisory Group, like most private wealth management firms, doesn’t “sell” our portfolio performance. The broader industry doesn’t sell performance because they are strategic, buy and hold, asset allocators and investment performance is considered to be completely random depending on the whims of the investment markets. It is far better to “sell” relationships. The relationship sale is much less dependent on volatile market performance that can be good or bad in any year, and much more dependent on selling things like trust, communication skills, dependability, organization, and financial planning benefits of all kinds. We understand the difference between selling features versus selling benefits, and clearly investment returns fall under the category of features. What are the benefits that we sell? It turns out that they are pretty much the same as those sold by the rest of the industry. In addition to the benefits mentioned above, how about less stress, more confidence in the future, and the ability to be happy in your life worrying about something other than finances. And of course, we sell ourselves.

I know we don’t sell investment returns, but it’s interesting to note that Pinnacle’s investment analysts got every major turn in the market correct since the end of the bear market in 2002 when we first started to actively manage money. The net result of overweighting risk in managed accounts in early 2003, underweighting risk by the summer of the 2007, and adding risk back to the portfolios by the beginning of 2009 has been a huge BENEFIT to our clients. They have earned higher returns with less risk than an unmanaged benchmark of stocks and bonds with similar risk/reward characteristics. Our moderate growth portfolios are generally only a few percentage points away from making all-time highs. A comparison to Morningstar’s Moderate Allocation universe of funds, which are managed with a similar risk exposure to our moderate growth portfolios, would result in our being ranked among the top 5%…if we were a mutual fund. This propensity to outperform is an interesting FEATURE to keep in mind.

For consumers of Pinnacle’s investment services, they will have to evaluate exactly how we managed to outperform. Is our process systematic and repeatable? What is the likelihood that we will continue to make good decisions in volatile markets? If we make a mistake, is it likely to be a big mistake or a small mistake? Could our clients do better themselves, or can they find another firm that does it better? These are all good questions and we stand ready to provide the answers to the best of our ability. But don’t misunderstand us…we don’t sell investment performance here.

Risk Management and Money Markets

I recently watched a video where a Chief Investment Officer stated that by utilizing a risk management methodology that allowed them to go to cash or money markets, “they were making the type of risk management used by large investors available to small investors.” Let me be clear about this. Large institutional investors will NEVER take a portfolio to a 100% cash position in order to best manage risk. I can think of two major reasons why that is the case.

First, institutional portfolio managers of large state, union, and corporate pension funds, endowment funds, and family offices for very large private accounts, are virtually all well-schooled in modern portfolio theory. These MBAs, Ph.D.s, and CFAs, believe that time diversification and asset diversification are the best methods to manage risk. Second, large institutional pension funds use an actuarial approach to managing risk by matching the maturity of their liabilities with the duration of their investment assets. For employees retiring 25 years in the future the investment with the highest return premium and the longest duration is common stock. For these investors, owning cash represents an unacceptable risk of mismatching assets and liabilities. The closest institutional investors might come to “going to cash” is to allocate some small and manageable portion of the portfolio to money managers that run strategies that allow them to zero out their “long” stock positions. Hedge funds in the market neutral and long-short space often get to 0% long exposure to stocks. However, these allocations typically represent a small allocation in an institutional size portfolio. In Pinnacle portfolios we call these managers “eclectic managers” and they currently represent about 10% of our total portfolio allocation.

Pinnacle Advisory Group does not go to 100% cash for reasons that having nothing to do with the views of institutional investors. I believe the basic idea that stocks will always deliver a premium to bonds and cash over long time periods is a dangerous proposition that can’t be proved by past data. Buying stocks at high valuations offers the virtual certainty of underperformance over long time periods. However, the reason that we don’t go 100% to cash is for the simple reason that doing so implies that you have 100% certainty that your forecast is correct and I don’t believe investors should take that risk. I realize that cash offers safety of principal in volatile bear markets and I also realize that certain investors will find comfort in a timing strategy that allows them to get 100% out of the stock market. I have no problem with their definition of risk or with a money management firm that offers it to their clients. I have often stated that active management comes in many flavors and consumers will choose managers that they believe in. But I do take issue with the idea that implementing extreme asset allocations at market turns is bringing the best risk management techniques of large investors to the masses. It is the little guys who go to cash. For the largest investors, it would never happen.

Pinnacle’s Proprietary Investment Process

Of late, for one reason or another, I’ve spent a lot of time describing Pinnacle’s investment process. For the record, the best explanation of our process is that we have a multi-faceted approach to decision making that considers fundamental or traditional valuation analysis, analysis of business and market cycles, as well as technical analysis of investor behavior. This is but another example of why we believe in diversification, although in this case it results not only in portfolios with diversified asset holdings, but a portfolio where decisions are based on more than one kind of analysis.

I’ve written previously in this space that I believe that investors who are interested in active management will first explore the technical method of tactically allocating portfolios. Using technical analysis has many benefits, perhaps the most important of which allows the advisor to develop several “rules” for following favored indicators. These rules then become a quantitative approach to decision making that is relatively simple and relatively effective. Most of the active managers that I’ve reviewed are using some type of quantitative system based on simple trend following or momentum rules – all of which are based on technical investing techniques such as relative strength, oscillators, trend lines, etc. The resulting system becomes a “proprietary decision making process,” a very valuable product to sell to investors. For the record, a proprietary process implies a secretive, valuable, exact, scientific, repeatable process that no one else can duplicate.

At Pinnacle we have also developed a proprietary investment process. It’s called “doing the work.” Unfortunately our process requires us to make qualitative as well as quantitative decisions about asset allocation. And to my knowledge, there is no easy way to make a decision based on the weight of the evidence as determined by our judgment, experience, and expertise. For us it means slogging through the 100-plus economic releases each month to find clues regarding the market cycle, Fed policy, currency direction, etc. It also means reading daily, weekly, and monthly research reports from dozens of brilliant analysts who disagree with each other all of the time. Marrying this process with our own proprietary quantitative approach is nothing but hard work. But it sounds a lot better when we call it our proprietary investment process. For the record, our proprietary process is inexact and messy, but I have a great deal of confidence that it is the lowest risk method for making investment decisions.

Found: A High Conviction Forecast

Task number two this weekend was to catch up on my investment research, a seemingly endless proposition that punishes my weekly tendency to procrastinate in my reading. Task number one was to write a marketing brochure for Pinnacle to use in a potential new venture. I have written our story so many times that it’s difficult to get overly enthusiastic about doing it again, but I am the Chief Investment Officer and explaining what we do is a big part of the job. An important part of our story is our belief that relative value investing makes sense. For us, relative value essentially means that we will vary our portfolio construction based on our conviction in our investment forecast. We measure our success in earning excess returns for our clients by comparing our results to a portfolio with a fixed asset allocation. The special name for this hypothetical portfolio is our benchmark, and if we are successful in identifying good investment values we will earn excess returns relative to our benchmark.

While pondering (once again) how to explain the intersection of benchmarks, value investing, tactical asset allocation, and high conviction forecasts, I decided to take a break and read a research piece from Lombard Street Research called, Deflation to hit Germany and America. Charles Dumas is the well respected analyst who penned this somewhat technical and very detailed piece on his views regarding the outlook for deflation in the U.S. and Germany. While I shouldn’t have been rewarded for deviating from task number one to dally in task number two, I couldn’t help but be struck by the certainty in Dumas’s forecast. In fact, the Pinnacle investment team reads hours and hours of research, and I can safely say that Dumas went way out on the limb of high conviction writing. Here are a few examples:

“For the time being, with stock and house prices down some 30-40% from their peaks, people worrying about booming asset prices causing inflation have to be seriously detached from reality.” Or, “In these conditions, financial collapse centered on the dollar is verging on the impossible.” And my personal favorite, “To talk of inflation resulting from this is plain stupid.” I say bravo to Mr. Dumas. We highly value analysts who advance clear points of view and back them with sound analysis. This is not to say that I personally agree with Lombard’s deflationary case for the world, which is by the way, rather gloomy reading. However, it is a good reminder of how our investment process works. When we occasionally have the same level of conviction as Mr. Dumas, Pinnacle clients can expect larger rather smaller deviations from our benchmark portfolio. And if our forecast is correct, it is from these conditions that we would typically generate the most excess returns for our clients.

Thoughts on Investment Time Horizons

Sometimes I pine for the good old days at Pinnacle when the prime ingredient for measuring investor success was patience. Back in the day when we were strategic buy and hold investors, the returns of the asset classes that we owned in our portfolio were assumed to be a given, as long as we waited long enough for them to appear. Since the underlying theory suggested that markets were always efficiently priced, and since our clients agreed that returns could and should only be measured over the “long-term,” we could asset allocate our portfolios based on past returns. With the backing of the financial media and virtually all of our industry pundits and thought leaders, everyone involved agreed that patience was the key to success.

Times have certainly changed for the Pinnacle investment team (Truth be told, in the old days we didn’t have a Pinnacle investment team because there wasn’t a need for one!). Today we actively manage portfolios to take advantage of changes in asset class valuations, changes in the market cycle, and changes in market internals such as investor sentiment. The challenge of this strategy is that in today’s markets the data comes fast and furious and the financial markets can be influenced by the news in unforeseen and unpredictable ways. The inevitable result of such fluid market conditions is that the holding period for securities in the portfolio continues to shrink. Where we used to hope to hold equity positions for periods of years, we now would be happily surprised if that were the case. The market rally since March 9th is a good case in point. As the markets have violently rotated from defensives to early cyclicals to late cyclicals, investors who were not nimble enough to follow the cycle missed out on excellent opportunities for excess returns.

Last week, our portfolio manager for our Dynamic Ultra Appreciation portfolios, Rick Vollaro, put on a trade to possibly take advantage of what we perceive to be the short-term overbought condition of the market. He sold a position in an exchange trade fund that owns the Materials sector and bought a 2x inverse position in the same sector, effectively reducing our equity exposure in that portfolio by 10%. He intends to take the trade off as soon as we get the correction that he is anticipating. The good news for me is that Pinnacle has the expertise and the technology in order to execute such an innovative transaction with ease. However, I can’t help but smile at the gigantic changes that have occurred in our portfolio management philosophy over the past 7 years. We wouldn’t have considered this trade, even in our most aggressive portfolios, as little as two years ago. Today we consider these kinds of transactions to be a reasonable and necessary part of our risk management process and an integral ingredient in our quest for excess returns in difficult markets. We’ve come a very long way from patience being the primary strategy we rely on to earn expected returns for our clients.

Portfolio Managers versus Money Managers

In my opinion there is an enormous amount of confusion about who the players are in the investment industry so here is my particular take on the subject. I define portfolio managers as investors who have the freedom to invest in multiple asset classes. Their portfolios are typically constructed with investments in U.S. and international stocks, U.S. and international bonds, U.S. and international real estate, commodities, and other exotic asset classes like managed futures, hedge funds, private equity, etc. While they have the freedom to invest in any mix of these assets that they like, in the traditional world of buy and hold strategic asset allocation virtually all portfolio managers subscribe to Modern Portfolio Theory to come up with the single best or most “efficient” mix of asset classes. The end result for portfolio managers is that the mix of the asset classes they choose never needs to be changed because markets are presumed to be efficient and investors are presumed to be rationale. In short, traditional buy and hold portfolio managers buy and hold asset classes in a fixed mix that changes very little over time while they patiently wait for the past performance of each asset class to materialize.

Portfolio managers invest with money managers like mutual fund managers or separate account managers to invest each asset class in the portfolio. A money manager usually is an expert in managing assets in one asset class, and his or her portfolio performance is compared to a one asset class benchmark. You can find money managers specializing in virtually any asset class, including all of the ones mentioned above. These are the managers who buy and sell individual stocks and bonds as institutional investors, and these are the managers you see on TV who comment on the current state of the markets. They have an immediate and vested interest in the financial news of the day as they actively manage their portfolios to try and beat their one style constrained performance benchmark. For example, a large cap value mutual fund manager who is trying to outperform the S&P 500 Index.

For most retail investors, their financial advisor acts as a portfolio manager. They invest in money managers in the form of mutual funds and separate accounts in order to own multiple asset classes in their client’s portfolio. If they are a traditional buy and hold advisor, once they buy these funds, there is little to do but explain how they perform to clients, check their relative performance once a year or so, and remind their clients to be patient until expected returns arrive, presumably some time in the future. Do not confuse these two types of managers. A portfolio manager who passively invests in money managers is not practicing “active” management. In contrast, Pinnacle Advisory Group actively manages portfolios at the asset class level. There is a huge difference between actively changing the asset allocation of a portfolio management versus passively owning active money managers in a portfolio. Don’t confuse the two.

Do You Hear That Sigh of Relief?

The stock market has come rocketing off the March 9th lows and the rally is now at 50%+ and counting. Buy and Hold investors who had been holding their breath and hoping that something positive would occur in the markets to rescue their portfolio are wondering if their prayers have been answered. Even though the S&P 500 is trading 35% below its October 2007 peak, and is still trading below its March of 2000 value, and even though portfolio returns have dramatically underperformed any reasonable and conservative estimate of growth for a decade, you can hear the strategic buy and hold crowd breathing a huge sigh of relief.

50% market rallies do a wonderful job of helping investors take their eye off the ball. While six months ago the media was screaming that buy and hold is dead, now that story is being put into mothballs while writers scramble to cover the next bull market. How sad. The buy and hold is dead story has nothing to do with short-term market fireworks in either direction, and everything to do with a theory that supposes that such extreme market volatility shouldn’t be happening in the first place. Active portfolio management is all about understanding the intersection of traditional market valuation, economic cycles, and investor behavior as measured by market sentiment and market breadth. It is worth repeating that classic modern portfolio theory and the efficient markets hypothesis (buy and hold) refute the need for any of the above. In theory, buy and hold investors can sit back and wait for anticipated returns to appear right on schedule, which is some unspecified time in the future. This remains a dangerous strategy for investors.

I am personally enjoying returning to my former status of investment genius as the bull market continues. The 2003 – 2007 bull market seems like it occurred a long time ago and I am not immune to feeling great about excellent year-to-date portfolio returns. But cyclical rallies in secular bear markets do not make the case for buy and hold investing. These are the rallies that need to be invested with caution and respect. Buy and hold investors who are just now looking up to see if the coast is clear just might be heart broken as structural headwinds inevitably crush buy and hold returns in a continuing secular bear market.

Looking for the Right Word

I have no problem with describing Modern Portfolio Theory as science. After all, Markowitz’s work did win a Nobel Prize for Economics, and for that matter, so did Bill Sharpe’s work on the Capital Asset Pricing Model. I believe that investor’s want to pay for science…and all that it implies. Science implies certainty, exactness, facts versus opinion, expertise, proof, and so on. Since investor’s want to buy science, it should be no surprise that investment advisors want to sell science. For four decades now the financial industry has successfully sold strategic asset allocation as science. But now that the problems with MPT are becoming well known, consumers of investment advice need to reevaluate the value proposition of any investment process that claims to be scientific.

I am still looking for the right word to describe active portfolio management where the decision making process is driven by a subjective, qualitative approach to asset allocation. I have described it as “art,” the antithesis of science. In my book, Buy and Hold is Dead (AGAIN), I contrast art with science as saying that art “lies in the eyes of the beholder.” One investor’s interpretation of the economic facts of the day can and will be different from another investor looking at the exact same data set. The experience, judgment, and wisdom that help an investor reach a conclusion are art, I said. The problem being that art conjures up all of the wrong images. Artists are erratic; art is hard to measure and impossible to repeat. If investing is art than it must be about guessing, hunches, flashes, intuition, and other non-sellable attributes.

So this morning I want to suggest active management as a craft. Yes, craftsmen are still artists, but it seems to me that we value craftsmen. If investing is a craft to be learned, then we imagine that it takes skill and not luck. We expect craftsmen to apprentice for years before they practice on their own because a craft takes judgment and experience, in a context that we value and appreciate. So for now on, I think I’ll describe investing as a craft to be learned. While everyone is not an equally good craftsman, we can all agree that the best of them deserve our respect and are worthy of our patronage.

What Would You Tell a 60-Year Old About to Retire?

A journalist recently asked me this question in an interview. To be honest, I might as well have been asked what the causes were of the Civil War. From the perspective of a trained financial planner and the Chief Investment Officer of a private wealth management firm, the question is, well….difficult. The writer was writing for the Wall Street Journal, and he was looking for some sound investment advice for folks who have been buy and hold, strategic investors for their entire investing life. Now they are faced with the rapidly changing paradigm in the investment community that buying and holding is actually a high risk strategy in expensive markets. As you may have guessed, I flunked the test. My answer wandered all over the place, and I didn’t make it into the article. However, I’ve been thinking about it a lot since then, so let me try again.

Mr. or Mrs. 60-Year Old, don’t spend too much. Americans are used to a certain lifestyle which is apparent in the size of our homes, the amount of traveling we do, our taste in home electronics, our…everything. Spend the money to work with a legitimate financial planner (a Certified Financial Planner, CFP®) and find out what lifestyle you can afford and learn to live within your means. Next, actively manage your portfolio. You can’t afford to buy and hold if the financial markets are going to deliver less than average returns for the next five to ten years. No one can accurately predict the future, but smart people are worried about the amount of debt in the world, and you had better plan for a low return world early in your retirement. Low returns won’t last for the rest of your life, but the portfolio returns you earn early in retirement are disproportionately important to you, so be prepared. Active management can add two or three percent (or more) per year to your returns over time if executed successfully, which could be critical to your success.

If you’ve invested your own money for years and that’s why you’re reading the Wall Street Journal (or fill in the blank financial periodical), you have to invest the time and treasure to become a different kind of investment expert. You can’t be a successful active manager of your money by reading the morning paper and watching CNBC when you come home from work. If you can’t see yourself doing the work, then hire someone to do it for you. Find a professional wealth manager that specializes in building globally diversified, actively managed portfolios. You may have always been a “do it yourselfer” when it comes to investing, but beware. The market is not likely to provide a tailwind to your investment mistakes going forward. You have to know what you are doing in the tough market environment ahead. Good luck.

Here Come the “Tactical Overlays”

The avalanche of press this year about the death of buy and hold investing has surprised even me, and I have been forecasting this change in our industry for just about a decade. Now that financial advisors and professional pension and endowment investors are paying attention, I am watching to see how the industry is going to address this problem. You have an industry that is populated by professionals who have passionately followed the buy and hold dictums of strategic asset allocation for their entire careers, and all of the sudden they need to come up with “the quick fix.” What should they do as pragmatic business people when the status quo about the “right” way to invest has changed, virtually overnight?

When it comes to personal financial advisors, those Certified Financial Planners (CFP®) who are my peers in providing “sophisticated” asset management for affluent investors, I have long predicted that the solution will appear in the form of some kind of technical analysis-driven process. Clearly the least expensive method for active management, in terms of both time and treasure, is to focus on technical trading methods. I can see new institutional level software (i.e., expensive) that will cater to big firms looking to add a “tactical overlay” to their current buy and hold, strategic asset allocation portfolios. In the world of pensions and endowments, my partner, John Hill, recently told me that the consultants to a non-profit board that he sits on recently offered exactly that. The endowment investment committee could remain strategic (buy and hold), or they could purchase the new razzle-dazzle tactical overlay that would change the asset allocation based on their new, proprietary, techno-sizzle methodology. If professional money managers are afraid that their clients are going to demand active management, I think the tactical overlay will be an easy sale.

Of course, the technical solution will not require that the consultant firms that have advised their clients to buy and hold for decades have an actual track record in active management. Or, for RIA’s (Registered Investment Advisors) catering to affluent clients, their new tactical overlay will not require them to actually learn about market fundamentals, do the research, invest in knowledge and people, or be responsible for the asset allocation changes that are integral to active management. They will instantly have a credible, saleable, technologically marvelous, scientific, and relatively cheap, solution to their problem. Since we (Pinnacle Advisory Group, Inc.) are still slogging along reading the research and actually doing the work, a theme that is mentioned several times in my book, I wonder if we somehow got it wrong?