Investing During the Global Recession and Beyond

I start with the following caveats.

  1. I clearly have no crystal ball. I found “my own inventive ways to lose money on a colossal scale during these last 15 months.” (Ben Stein, NYT, December 26, 2008) – A great line – it made laugh when I first read it!
  2. The Asian Development Bank puts global financial losses at $50 trillion for just 2008. Government stimulus monies are not sufficient to bail us out soon. Times are uncertain and difficult.

This is no time to take chances in the stock markets. Check out what Roubini says http://www.rgemonitor.com/roubini-monitor/255909/how_low_can_the_stock_markets_go__much_lower. Better still, read carefully what John Mauldin says – http://www.frontlinethoughts.com/article.asp?id=mwo022709.

Let me supplement these readings with a few of my own thoughts. There are two primary reasons for the global recession – wealth losses (probably 75% completed) and wage losses from growing unemployment (just starting). Both will cause consumption cutbacks, and as I indicated in my last posting, US truck and auto sales are off 50% and consumer durable purchases are down 25%. We have probably had most of the collapse in global expenditures resulting from the real estate downturn, the credit freeze, and stock market collapse. But the cutback in consumption resulting from the job losses and consequent drop in income is only starting.

However, there is something every investor should keep in mind: a very large portion of any stock market recovery takes place in the first year of recovery. The following table demonstrates this fact. Look at the bottom line: on average, the S&P has come back 32.8% in the first year of recovery. This compares with average annual returns of 13.4%, 4.6%, and 3.8% in the following years.

Average Returns of S&P 500 After

Declines of 20% or More Since 1956

Market Bottom Year 1 Year 2 Year 3 Year 4
Sept. 2002 22.20% 11.90% 10.20% 8.70%
Nov. 1987 18.80% 24.40% -5.30% 16.40%
July 1982 51.80% -7.30% 26.70% 23.90%
Sept. 1974 32.00% 25.50% -8.30% 6.20%
June 1970 35.70% 8.60% -2.70% -17.50%
June 1962 36.10% 17.40% 6.90% -14.90%
Average 32.80% 13.40% 4.60% 3.80%

Is this pattern going to hold up following this collapse? And even if it does, how long before we get to the market bottom? I do not know. But it does suggest one has to be prepared when evidence of a global recovery is at hand.

Before this collapse started, I was writing a book on the global financial sector (I canned the book idea when I realized the print media is finished). I developed a number of road maps on the sector. One is presented below. In essence, it shows that the salesmen/collectors get the money from

The Global Road Map of Finance – Institutional Investments
Income Finance
Recipients Collectors Intermediaries Investors Vehicles
Individuals Banks Collectors Collectors Direct
Commercial Banks
Institutions Savings Banks Consultants Intermediaries Stocks
For-Profit Credit Unions Direct (via Brokers)
Financial Investment Banks Others Mutual Funds
Non-Profit Stock Brokers Hedge Funds
Risk Adjusters Private Equity Banks
Governments Mutual Funds Venture Capital Checking
Savings
Wealth Managers CDs
Insurance Secondary
Life Markets
Casualty
Pensions
Private
State/Local
Federal

Income Recipients, pass it on to intermediaries, and then to those who actually invest the money (Investors). I have highlighted the Consultants in this map. They are new and very important (more about them in a later posting). They develop the dominant investment strategies for insurance companies, pension funds, wealth managers, etc. They also recommend Investors to their Salesmen/Collector clients.

Have you heard of “Asset Allocation”? Of course you have. Where did the idea come from? The consultants. It is a very good approach for the Salesmen/Collectors.

Let me take a small detour into the history of investment theory. Everything started with probability theory developed by Bachelier, Einstein, L’evy, Kolmogorov, and Wiener. Paul Samuelson is credited with developing the mathematical theorem showing that “properly anticipated futures prices fluctuate randomly”. John Muth formulated “rational expectations theory” which states that individuals and companies, acting with complete access to the relevant information, forecast events in the future without bias. And Burton Malkiel has presented all of this work in a book with direct application to personal investing.

And what does it all mean for the investor? It means that the best assumption to start with is that all available information on companies is reflected in their stock prices. And consequently, the price of every stock is just as likely to go up or down. This means the investor has 50-50 chance of picking which way a stock will move – not a good bet because you don’t want a 50% chance that you will lose money on your investment. The sensible conclusion: don’t bet all your money on one horse. There is a corollary to this: don’t take too seriously anything you hear about why you should buy an individual stock: if new information is almost instantaneously reflected in stock prices, what makes you think you are going to get that information in time to “cash in”? Remember that every financial house, mutual fund, etc. has multiple analysts working full time to take advantage of any new news that comes out. Let me be more concrete: a mutual fund managing $1 billion is not at all unusual: there are now 1,596 such US funds. A billion dollar fund will generate yearly $7.5 – 10 million in management fees. You can hire a lot of stock analysts and rent many Bloomberg terminals for that sort of money.

Let’s return to the one stock 50% chance of it going up and down point. Suppose you pick two stocks. There are then four possible outcomes: both stocks go up, both stocks go down, and one goes up while the other falls. Each of these outcomes has a 25% probability. The both stocks going down outcome is analogous to betting all your money on one stock. And note, the probability of this outcome has fallen from 50% to 25%. The lesson from this exercise is that diversifying by holding more stocks reduces your potential gains and losses. And with more stocks, your risks fall further. Mutual funds provide an opportunity to diversify further, just as buying stock indices do.

So far, so good. There is more that is not so good. Over the last decade, the Consultants have taken the meaning of diversification further. They advisors have preached proper “Asset Allocation, don’t put all your eggs in one basket. That means you should spread your equities between categories either defined by industry, e.g., Consumer Goods, Media, Software, Business Services, Utilities, Telecommunication, Hardware, Energy, Financial Services, Industrial Materials or “style”, e.g., Small Value, Large Core, Small Core, Medium Value, Medium Core, Large Value, Large Growth, Medium Growth, or Small Growth.

Most Salesmen/Collectors will ask you how you want your funds invested. And they have categories for you to choose, e.g., conservative, value, growth, aggressive growth. For each of these categories, they will have a sub-set of categories, e.g., small cap value, large cap growth, international. They have asset allocation percentages for each sub-category.

Consider how convenient it is for Salesmen/Collectors to use this asset allocation approach. First, it helps if there is any complaint about performance. If you complain, your Collector/Salesman will point out that you agreed to have your funds invested in accordance with your asset allocation categories. In short, you will be told your funds are being invested as you wished. These categories/asset allocation rules protect the Collectors/Salesmen from your complaints.

Second, these categories and asset allocation rules take your attention away from the questions that should be most important:

  • exactly which stocks, mutual funds, ETF’s etc. chosen;
  • how do they compare to other similar investments, and
  • how are they performing?
  • Of course, it is valuable to have short descriptive terms to identify one’s investment objectives. But how complex should these be? How about just Conservative, Moderate and Aggressive with high yield or high capital gains for each? For anything more than these six categories, investments should be economically justified.

One final observation: Morningstar rates fund performance by categories. None has done particularly well over the last 12 months:

Category 1 Year Return
“Sector”
Technology -37%
Communications -43%
Natural Resources -53%
Health -24%
Utilities -39%
Real Estate -55%
Financial -54%
World Allocation -34%
Latin America Stock -60%
Pacific/Asia ex-Japan Stk -47%
Diversified Emerging Mkts -54%
“Style”
Large Growth -39%
Mid-Cap Growth -42%
Mid-Cap Blend -43%
Small Growth -42%
Large Blend -42%
Mid-Cap Value -44%
Miscellaneous Sector -43%
Large Value -44%
Small Blend -44%
Small Value -44%

My recommendation: when you finally decide to invest again, avoid anyone who talks about asset allocation. Focus on picks that make economic sense to you.

The content above was saved on the old Morss Global Finance website, just in case anyone was looking for it (with the help of archive.org):
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