USVM - Retro Forward And Cycles - Weekly Blog # 792

2023-07-10 13:04:00 ET

Summary

• The money management profession believes stocks and bonds have separate levels of risk of decline. The way this is expressed and managed is through a ratio of stocks and bonds, for example 60/40.
• The purpose of the ratios was to manage risk. Today, there are many stocks that are less risky than some bonds or other credit instruments.
• The investment media has declared the 60/40 strategy dead following approximately 40 gainful years for bonds and 3 years of decline.

Managing Money Motivations

There are two very different parties in a professionally managed investment account. The first is the owner of the capital who is primarily interested in investment performance, usually using current performance as representative of future performance. The second participant is the manager of the account who wishes to maintain the relationship for a long time. The fully loaded cost of acquiring the account is usually not earned back immediately. Thus, the first rule for the manager is not losing the account. This is somewhat different than the motivation of the owner of the account.

Best Defense is to Keep the Account

Managers assemble a number of different securities into a portfolio so that not all of them decline by the same amount in most down periods, hopefully some will rise. One of the standard ways of accomplishing this task is diversifying the investment characteristics of the securities. The most important characteristic of a security is deemed to be its risk of declining.

The money management profession in many cases believes stocks and bonds have separate levels of risk of decline. The way this is expressed and managed is through a ratio of stocks and bonds, for example 60/40. This means 60% in stocks and 40% in bonds. The investment media has declared the 60/40 strategy dead following approximately 40 gainful years for bonds and 3 years of decline. The average performance of 107 mutual fund sectors over the last three years through Thursday, 41% have lost ground. All but one of the declining sectors were fixed income-oriented. The one exception was Chinese Regional funds. (This confirms my view that we have been in a period of stagflation for some. We will be dealing with Chinese-oriented funds in a subsequent blog.)

Understanding the Use of Numbers

The purpose of the ratios was to manage risk. Today, there are many stocks that are less risky than some bonds or other credit instruments. A better name for this diversification function would be low risk, or high quality/high risk, or low quality. One should recognize that like almost everything else in life, risks move in cycles. Some Scottish Trusts started life owning only British gilts, and over time introduced stocks. Today, some of these trusts are almost exclusively invested in stocks, while maintaining their historical names.

In the US, trust accounts have gone from 100% bonds to a 50/50 split. Trusts then moved to 60/40, with some advocating for 70/30 and even 80/20. What brings this concept of cycles to mind is a 1957 or thereabout discussion I had with the venerable Professor David Dodd, who was teaching Securities Analysis at Columbia. He emphasized the use of balance sheet-related data in securities selection. With the arrogance of a student, I suggested growth had become more important since the Depression, when he and Ben Graham wrote their seminal textbook on Securities Analysis.

He closed the discussion by explaining that the fund he was involved with had made lots of money buying discounted value securities. However, ten years later, growth stocks led the market. Perhaps the good professor was right for professionals. Many growth stocks fell, including from the ’73 peak, whereas his value stocks held up much better. This experience convinced me that the appropriate diversification schedule is a cyclical pattern.

Are We Near a Change in Valuations?

There is some evidence that it is possible, if not likely, we are near a change in valuation. Fixed-income yields have been inverted without a marked recession for over a year. Last week, the US Treasury yield spread between the two-year (4.93%) and thirty-year (4.03%) was a remarkably narrow 0.9%. This suggests the long-term future is not as attractive as the current period, with potential recessions in the next thirty years.

This appears to be at variance with current estimates for S&P 500 stocks. Net income changes in the second and third quarter of 2023 are expected to be -8.6% and +1.7%, respectively. (These are net income changes, EPS estimates are expected to be -6.4% and +1.7%, respectively. This shows the benefit of firms buying back their common stock. Buybacks potentially help managements with their stock options, but possibly not in the long-term improvement of the value of the company.)

The “bulls” in the market are possibly relying on one of the oldest market forecasting devices, The Dow Theory, which requires both the DJIA and the Transportation Index to move in the same direction. In the latest week, only two of the 30 DJIA stocks rose, with thirteen of the 20 transportation stocks rising. At this time of year, seasonal inventory is moving toward the stores, but many stores are closing or hiring inexperienced staff.

With services and non-durables growing while durables are not, there is a long-term structural problem for the economy.

Conclusion

Changes are coming and we need to manage them, or they will manage us.

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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