espite a mild setback in September, financial markets continued their
remarkable revival following a near-death experience in March, with the
major US equity averages rising between eight and eleven percent during
the third period of the year. Much of the buying interest remained
focused on the technology sector (at one point, US techs’ market value
exceeded that of the entire European stock market), though at times,
interest did seem to broaden into more unloved economic regions.
Higher prices and swelling valuations, inflated by the ample monetary
liquidity provided by central bank operations worldwide, have affected
nearly all asset classes, from traditional equities, all manner of
fixed-income securities, and commodities, to obscure derivative
instruments and foreign issues (central banks have directly participated
in the demand for financial assets through their massive purchases of
bonds, mortgage securities, and even ETFs). While this situation must
certainly gladden the hearts of existing holders of such assets, it has
wreaked havoc with the strategies employed by some large institutional
fund managers. Facing a volatile election period in the US, combined
with continuing disruption due to the coronavirus pandemic, many of
these professionals are looking for ways to hedge their portfolios in
the event of another sharp stock market setback.
Historically, US treasury securities were well suited for this purpose,
as they are relatively secure credit-wise, and trade in a highly liquid
market, meaning they are easy to buy and sell in large quantities.
Another advantage of the treasury market was that it tended to react
positively to stock market panics, and the accompanying rise in bond
prices nicely offset some of the declines in stock positions. Currently,
however, the high valuations and low yields of US and other sovereign
obligations make them unattractive as hedges. They may be subject to the
same forces that could precipitate a fall in stocks, such as rising
interest rates, or unexpectedly severe economic fallout from the
pandemic. Their failure to provide much protection during the unsettled
stock market in September gave fund managers another reason for pause,
turning instead to other assets for protection, including options,
derivatives, foreign bonds, and currencies (indeed, short-selling odd
combinations of foreign currencies seems to be the trade du jour among
this group). It goes without saying that all of these alternatives are
much further out on the risk curve than US treasuries.
While these sorts of machinations among professional traders seem remote
and vaguely questionable to the lay person, such strategies are relevant
to ordinary savers and investors, if the latter happen to own fund
shares or have retirement money invested with professional managers.
Additionally, the same forces challenging professional decision-making
affect the “mere mortals” who seek to navigate the current financial
environment. Inflated asset prices are making for difficult choices all
around. Much has been made recently of the demise of the traditional
portfolio mix of 60% equities and 40% fixed income (“60/40”). According
to this old rule of thumb, the relative price stability of bonds, and
their higher income, will cushion the volatility of equities and provide
spending money, while stocks are expected to enhance capital and protect
living standards from inflation over time. The 60/40 mix has worked well
for investors, producing returns of about 8% annualized over the last
ten years and 10.2% since 1980, well over the inflation rate of 2.9%
annualized during the 40-year period. But past results are no guarantee
of future success, and with prices at record highs and yields at record
lows, it seems highly unlikely that high single-digit results from a
60/40 mix will be enjoyed during the next decade. Given the high prices
for bonds, it is even conceivable that they could have a negative
impact on capital, possibly for extended periods of time; if interest
rates rise — almost a certainty, given enough time
—
bond prices could drop
precipitously.
Stock prices going forward will probably be no slam-dunk either,
although the long-term outlook may not be as dire as some predict. Some
observers foresee a “lost decade” for equities; others see a “raging
mania” driven by monetary and fiscal stimulus efforts that will end
badly. But much of the “mania” is in the tech sector, while broad swaths
of the equity list are reasonably valued. A “rotation” of interest away
from the popular stocks and toward out-of-favor groups could produce
surprisingly positive movements in the averages, but with stocks,
nothing can be counted on. Hence, the 60/40 stock/bond mix could be
disappointing, especially if the disinflationary spell of the last four
decades were to break.
These issues are extremely important because the allocation of one’s
resources plays a significant role in reaching future financial goals.
So what is the best way to think about facing this challenge in the
current climate? We favor an approach rooted in history, as follows:
In investment literature written prior to the 1930s, we encounter a
sharp distinction between investment and speculation, in which
investment is almost exclusively identified with fixed-income
securities — typically bonds or mortgages
—
while
speculation is the realm of the stock exchanges. This was a
broadly-accepted view which held that investment implied solidity,
permanence, safety of principle, and income — the attributes of a “solid
credit” type of commitment.
Common stocks, it was believed, offered none of these qualities; those
who operated in them were interested solely in benefitting from a change
in price, preferably in the shortest time possible, which is the very
definition of speculation. Investment analysis focused on finding and
selecting the most entrenched of fixed-income instruments for income and
capital preservation.
To be sure, this distinction was not strictly followed in practice —
one
could, for example, purchase bonds with “speculative characteristics”
whose price offered chances for profit in addition to income. And
beginning in the 1920s, the attitude toward stocks began to soften as
evidence mounted that equities, when properly utilized in diverse
portfolios, offered important advantages, most significantly protection
from currency debasement (inflation). The Great Crash of 1929 and its
aftermath proved a severe setback to the popular perception of equities
as anything other than a mode of gambling, but the notion that stocks
could properly be seem as legitimate investment vehicles was never again
subject to serious challenge.
In the ensuing decades the demise of the old investment/speculation
distinction has been accompanied by broad acceptance of equity
investment by professionals, members of the public, and even
governmental authorities (investment for trusts is no longer subject to
strict oversight, for example). The change in attitude has brought
important benefits, among them better returns for investors and
retirees, and, likely, a lower cost of capital for American industry.
But the ending of a clear separation of investment and speculation has a
negative consequence, in our view. Nowadays, almost anything that
is done with money in connection with securities is considered
investing, including day-trading, options, futures contracts, and
derivatives. The failure to use an analytical framework that
incorporates a recognition of speculative outcomes can also lead to
misleading conclusions. For example, returning to our 60/40 model, the
financial press reported that it produced a return of 7% so far in 2020,
but that included an 11.3% return for US treasuries —
a figure that
includes price change. The income yield was probably no more than
2%. The remaining 9% price appreciation, the direct result of collapsing
interest rates, was far from certain; there is no way that such a bond
would offer the capital protection presumed in the model with any
reasonable degree of confidence.
With this discussion in mind, we return to our asset allocation dilemma:
what is the investor to do in the current environment? For professionals
seeking to avoid an anticipated downturn (a speculative stance according
to our historical perspective), there is almost no place to hide in a
world in which all assets have inflated together. For those with less
than mega-sized portfolios there is, at present, almost nothing to
replace the stability and income traditionally provided by good quality
bonds. Proposals for alternatives —
private equity, foreign stocks, and
real estate, for example —
have their own drawbacks related to access,
liquidity, and risk. Additionally, none of these exactly represent
undiscovered country, as too much money has been chasing too few assets
in these areas for quite a while.
One asset that we favor, and one that is usually scoffed at for its
meagre return, is simply cash (or “cash equivalents:” very
short-term fixed-income instruments). Yes, cash offers little income
currently, but, importantly, it provides stability in a very uncertain
time that could, possibly, lead to rising inflation and interest rates,
which would prove quite disruptive to market participants unaccustomed
to such financial stress. Cash also has tremendous optional value,
meaning that it holds its value when all else is caving in, giving the
holder what amounts to a free call option to purchase financial assets
at low prices. It is no surprise then, that Berkshire Hathaway, in
keeping with long practice under conditions of scarce opportunity, holds
a cash hoard of approximately $140 billion at last count, invested in
treasury bills earning practically nothing. On Wall Street, “cash is
trash” when markets are rising, only to be desperately sought after in a
market panic. Since we can predict neither, in a situation offering few
attractive alternatives, we believe the cost-free option of cash is a
reasonable choice.
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