As an investment manager charged with shepherding a client’s assets through thick and thin, we think it’s important to continuously stress test our investment approach. Should we begin to incorporate something new in order to adapt to a fundamental change in the landscape (or not)? And what is ‘fundamental’ versus marginal? It’s a difficult process. The adage, ‘if it ain’t broke, don’t fix it,’ comes to mind, but we don’t pretend to own the magic formula either. In the end you have to go a certain direction with conviction that is supported by facts, figures, and experience (and emphatically, not ‘hope’). The worst thing an investment manager can do is join the mob when, at the next turn, the mob control awaits. We find it helpful, in our endeavor to challenge the approach, to read up on history.
“Investors are, once again, throwing caution to the wind. There seems to be complacency, perhaps even a disregard, to some underlying risks. The euphoria evident in the late 90’s is not characteristic of today’s market, but it shares in common a very low investor expectation of real loss. This is dangerous. Look no further than bond yields. There are some highly questionable corporate bonds paying only 1% more than the US government’s debt. Profit margins are as high as they have ever been (about 9%) and earnings have been outpacing overall economic growth for 4 years. If this rosy picture were likely to hold up, then I would be heavily allocated to equities. But it will not, so I am not.”
That was an excerpt I wrote to clients in January 2007. I could use it today almost verbatim. The recession officially took hold in December 2007, and the financial crisis, tipped off with the Bear Stearns debacle in the Spring of 2008. Stocks really didn’t wake to the ‘complacency’ until the Fall of 2008, as we all, undoubtedly, would like to forget (and perhaps we have). In 2007 the S&P 500 Index returned 5.5%. In 2008 it was slipping modestly before plummeting 37% for the year. From peak (October 2007) to trough (March 2009) the S&P dumped about 56%. What’s also interesting about this excerpt are the data points. The credit spreads between corporate and government debts were very low as they are today. As for corporate profit margins, well 9% then and 10% today. The fundamentals aren’t that different now as then. The valuations aren’t that much different now as then. The backdrop is different though, as it always is. The forces causing the dislocations are different, as they always are. This time around the economic historians will cite the reckless government deficits and monetary policies as the driving forces. As for our investment approach, the fundamentals always win the war.
