January 2011: Migrating to Higher Risk, Changing Risk-Return Tradeoff

2010 in Review

Update on Quantitative Easing

In the latter part of 2010 the Federal Reserve embarked upon a second round of Quantitative Easing (“QE2”).  This program creates money electronically (the modern day version of printing money) to buy Treasury bonds, hoping to drive interest rates lower and thereby stimulate the economy.  This set financial markets awash in easy money looking for a place to reside. QE2 hasn’t reduced interest rates as intended.  Instead, it’s produced a surge of speculation in stocks and commodities.

The Federal Reserve is indirectly encouraging stock purchases, irrespective of valuations (that we believe are already slightly expensive). Ultra-low interest rates make cash deposits and bonds relatively less attractive investments than stocks, inducing formerly conservative investors to begin buying stocks.  The Fed is hoping that a rising stock market will create a “wealth effect” that will cause people to feel better off financially, ramp up their spending and provide a boost to the economy.  Perhaps, but how long can that last?  Like a cup of strong coffee, the short-term artificial boost will wear off.

Migrating to Higher Risk

The policies of the Federal Reserve have made holding cash so unattractive that, in effect, they are coercing investors to migrate into riskier investments, hoping to enhance their returns.

Investors that are normally risk-averse are getting so fed up with low yielding money market funds, CDs and bonds that, out of frustration, they are slowly giving up, seeking higher returns by shifting into riskier investments.  Unfortunately, investors seeking higher income out of desperation are increasingly willing to abandon concerns about risk, like credit worthiness or vulnerability to price declines if/when interest rate increase.  This especially applies to long-term bonds whose prices are most adversely impacted by rising interest rates.  Bond investors are also reaching out to riskier investments like stocks and commodities, taking on higher levels of risk that were judiciously avoided in the past.

Chasing higher yielding investments is always punished sooner or later.  That’s just the way it works.

Stock Selection Takes a Holiday

As speculation increased last year, the largest gains in the stock market went to low quality companies with unstable earnings, little or no dividends, high indebtedness and high sensitivity to economic cycles and business risk.  The way to make money in the latter part of 2010 was to seek ever-increasing amounts of risk, regardless of how negatively skewed the risk/reward tradeoff became.  Less concern was being given to the downside implications of going further out on a limb.  In contrast, our charter is to seek profits while being mindful of risk and the preservation of your capital. Seeking ever-increasing investment risk can look tempting at times, but should be avoided without the prospect of commensurate rewards.

The types of stocks that prospered the most in 2010 were precisely the types of stocks that we and our favored mutual fund managers shun.  Our preference is for stocks that are cheap by traditional measures of valuation.  In addition, we also favor quality companies with well-managed businesses, solid financials (including a low reliance on debt) and whose futures are not reliant on the vagaries of continued speculative support.

John Hussman (source: click here) stated it well when he said,“… securities demonstrating reasonable valuation, stability, quality or payout have been virtually abandoned by investors” and “The problem with this outcome is that the speculative factors being rewarded over the short-term have nothing to do with the characteristics that have historically been rewarded over the long-term. Despite various periods where valuation is out-of-favor, value has been the clear winner over time.”

This reminds us of an inescapable truism in investing --- over time, price always follows value.   We are confident that this time will be no different.

Investors’ Dilemma

Investors are caught in a dilemma: should they speculate or temporarily settle for low returns?  Faced with record low interest rates and the prospect of rates staying low in the near future, many investors are acting on a false dilemma, considering only two possibilities:

a. stay ultra-conservative, concentrating only on protecting their capital and settling for near-zero cash returns, or

b. reach out to riskier stocks and bonds, taking on much more downside risk that they previously avoided, with the hope of attaining higher returns.

At Asset Allocation Advisors we believe there is a better alternative that is attentive to managing risk -- construct portfolios with the following characteristics:

1. Below average stock allocations while continuing to seek quality companies with attractive valuations,

2. Below average bond allocations limited mostly to short and intermediate maturities with less price vulnerability to rising interest rates,

3. Above average cash allocations that enable exploiting future opportunities to profit when weaker prices appear, and

4. Seek potential currency gains from short-term foreign bond investments that offer the potential to profit from a weakening dollar.  Trillion dollar federal deficits and manipulating interest rates to artificially ultra-low levels is a prescription for undermining the value of the dollar.  A weaker dollar drives foreign denominated investments higher as their currencies appreciate relative to the U.S. dollar.

The Price of Being Different

Our investment philosophy precludes us from speculating. We have said many times before that you cannot do what everyone else is doing and expect above average results.  Unfortunately, being above average requires being different and, at times like this, a willingness to be out of sync with the crowd.  That can entail occasional periods of underperformance.  We are willing to pay that small price and believe this is the best path in our quest for superior long-term returns.  We trust that you, too, prefer a strategy of caution and prudence over the urge to participate in mounting speculation.

Thank You!

We are grateful for your friendship, support and continued business.  Thank you. Please accept our wishes that you and your loved ones are blessed with a healthy, safe, prosperous, and joyous New Year!

*** Greg Schultz & Bruce Grenke

© Asset Allocation Advisors, Inc. 2011