Sunday, February 21, 2010

Buy and Hold or Dynamic Asset Allocation/Trading: Long Term Secular Bull and Bear Markets/ Australian currency and the Carry Trade

1. LONG TERM BEAR AND BULL MARKETS: When to Buy and Hold/When to Transition to a More Dynamic Process: This is an important topic that is frequently discussed in my blog, and I believe it is worthwhile to summarize some of my thoughts. I know that many investors focus their attention on what stock to buy or to sell, or the new hot mutual funds. The most important decision is the one involving the big picture, and I don't mean the particulars of your own circumstances looking out into the future. I am talking about the ebb and flow of historical events that are the the most important factors to understand. And the most important big picture category is whether stocks are in a long term "secular" bear or bull market, and the underlying reasons why stocks are in one or the other.

If I had enough money to make an initial investment in the S & P 500, and hold for sixty years or so without having any situational risk that would require me to dig deep into those funds, a buy an hold strategy advocated by the likes of Professor Siegel or John Bogle might make sense. Starting on 1/1/1951 through 12/31/2008, the S & P 500 would have had an annualized return with dividends reinvested and after inflation of 6.49%. CAGR of the Stock Market: Annualized Returns of the S&P 500 While I was born in 1951, I did not have any money to invest at that time, nor did I have any significant funds for the next twenty-five years thereafter, which sort of cuts down on that 60 year time span. I started to invest when I was 16 with money saved working in the summer at less than $2 per hour so not a great sum to start.

As I mentioned in several prior posts, the problem with buy and hold is that there have been lengthy periods since 1951 when my average, annualized, inflation adjusted return would have been negative. I will break the periods into what I would characterize as long term bear and bull markets from 1/1/1949 with dividends reinvested:

1/1/1949 to 12/31/1965: 14.4% annualized after inflation
1/1/1966 to 12/31/1981= -1.04% annualized
1/1/1982 to 12/31/1997 (part of those years I would not include): 14% annualized after inflation
1/1/1998 to 12/31/2008: -1.44% annualized

Maybe investors need to focus on the foregoing more. During the long term bear cycles, the returns would be worse for an investor who, for example, was buying stocks in October 2007 at the tail end of a cyclical bull move within the context of a long term secular bear market.

As a reminder, I define a long term secular bear market as consisting of several cyclical bull and bear cycles of relatively short duration, at least one catastrophic phase (losses exceeding 50%), with the end result after fifteen or so years to be a negative inflation adjusted return and/or the nominal average close to the starting point of the period. I would just add around five years to the average duration of a secular bear market for an event like the Great Depression:

1/1/29 to 12/31/1948 + 1.33% S & P after inflation and with reinvestment of dividends.
Jan 1929 DJIA 317.51
Dec 1948 DJIA 177.30


The depression years were marked by several years of deflation. Reinvesting the dividends during the down years would have helped the overall return when the market started to recover in 1942 with a more sustainable up move and less severe shocks to the downside. (As I recall, the pivot point was the American victory over the Japanese navy at the Battle of Midway in June 1942. On June 1, 1942, the DJIA was at 104 and had risen to 212 by May 1946).

A. Some Reasons for Recent Cycles: There are many reasons why these long term cycles repeat themselves. One reason is that most people never really learn much of anything from history. It is more interesting when they fail to learn anything which is worthwhile from current history which they experience as adults. Their minds are simply closed to information or analysis free from ideological predispositions.

Another explanation would be just to say that the seeds of the long term bear market are planted during the long term secular bull market. A lot of mistakes can build up in the euphoria of a long term bull cycle for the economy and stocks. One of the worst things that could happen to homebuilders was to have good years fairly solid from 1992 to 2006. So, many of the them lost everything that they made in 15 years during the next two.

Psychological issues also become important during the later stages of the long term bull cycle, as greed and stupidity become the dominant emotions in the investment process. Would you now characterize the Nasdaq valuations from 1999 as smart or stupid? The market is taken to a point when valuations are clearly excessive. This was the case in 1999 (and 1969 or 1929) for the stock market.

The bursting of the stock market bubble in 2000-2002 masked the underlying problem that was both the foundation of the long term bear market starting in 1997 and a propellant for the bull market starting in 1982. One propellant for the bull cycle was ever increasing debt incurred by American consumers, whose spending represented about 70% of U.S. GDP. The U.S. government, starting with the Reagan administration who increased the national debt by over threefold during his 8 years in office, started to run large deficits during several administrations. Both of those events were the catalyst.

I have previously referenced the following linked chart that shows household debt to disposal income in the U.S. since 1961. /www.invescoaim.com/pdf/ConRec.pdf Between 1961 to 1985, household debt fluctuated around 60% of disposable income, give or take a few percent. Starting in 1985 (the long term secular bull market started in August 1982), the ratio moved from 64% in 1985 to 133% in 2008. The U.S. was not alone in fueling economic growth by borrowing and spending ever increasing amounts of money. It was a widespread phenomenon particularly in developed economies around the world and encompassed both individuals and their respective governments, as in the U.S.

After the end of WW II and prior to the commencement of the Reagan Presidency, every administration starting with Truman and including even the much maligned Jimmy Carter, had reduced the nation's debt as a percentage of GDP during their respective terms. National debt by U.S. presidential terms That trend reversed during the two terms of the Reagan administration and accelerated into George H.W. Bush's four year term. The Near Depression in 2008 and its aftermath will merely accelerate the day of reckoning for the U.S. government.

The American consumer is basically tapped out as the engine for worldwide growth. The American government, now incurring annual deficits per year greater than the total debt that the nation incurred from 1776 to 1980, will have to retrench soon. Within a few years, the American consumer will have their balance sheets in much better condition then now and will be able to resume a higher and more normal level of spending. However, they will be far less important as engines of worldwide growth in the coming decades than during the fifty or so years following the end of WWII. I would further expect joblessness to remain at historically high levels for years to come in the U.S.

The next next long term bull market will have as its impetus spending by consumers and governments in what is called emerging markets now, but a new name will have to be assigned to them in years to come. For the growing middle classes in those countries, the question is when will their numbers increase to the point of being able to sustain long term worldwide economic growth, similar to the role played by the American consumer prior to 2008. My guess is that the mass will reach a flash point in another two or three years. This topic is of course not original with me and I have referenced some studies by Goldman Sachs on this point in previous posts: BRICs (Goldman Sachs) & www2.goldmansachs.com/ideas/global-economic-outlook/expanding-middle.pdf

Another major impetus in the previous long term bull (b. 1982 & d. 1997) was technological innovation primarily in computers which improved productivity, and helped to keep inflation low. It was also invaluable to have a federal reserve chairman, Paul Volcker, who stamped out hyper inflation and provided the necessary monetary conditions for the economy to grow in a sustainable and healthy way, with the importance of technology, increasing debt levels, & federal reserve monetary policy often overlooked by the True Believers in assessing what actually happened during the 1980s. More Meanderings on Corporate Tax Rates & The Multitude of Factors Impacting Growth.

Now, the TBs, holding opinions with the ferocity of a religious zealot, believe that Bush's tax cuts were the path to perpetual growth. To the extent there was any growth during the Bush years after those tax cuts, it was due primarily to ever increasing levels of debt and by the spending of those borrowed funds. The end result was a Lost Decade-no job growth, no asset growth and the average family would be worst off in 2010 than in 2000 Also A Lost Decade for Jobs & Income Growth Adjusted for Inflation W's News conference: Reflective or disingenuous? What Will Produce Growth after the Age of Leverage? (WSJ article: Bush On Jobs: The Worst Track Record On Record - Real Time Economics - WSJ and WP article: lost decade for U.S. economy, workers).

I am not making a political statement about republicans and democrats and their respective levels of fiscal irresponsibility. Instead, I am just talking about investment cycles and some of the reasons that they occur with regular intervals. Fifteen years is about how long it takes for greed and stupidity to gain the upper hand and administer the coup de grĂ¢ce to the long term bull market. Then it takes about 15 years to work through all of the problems created during the bull cycle, with the most important one from the last cycle being the exponential and improvident growth of credit and leverage.

If I was going to make a long term political prediction, I would just say that the GOP will take control of the Senate and the Presidency in 2012, assuming they are not really stupid with their nominee for President by selecting someone like Sarah or Glen Beck, which just caused me to cringe after just writing that, and the GOP will gain control in the House decisively in 2014 (possibly by a narrow margin in 2012). The GOP will receive the credit for a long term recovery which will start at the end of the Beanpole's first and last term by a majority of the American electorate, even though they would merely be the beneficiary of fundamental economic forces that have nothing to do with their ideology and policies, much like what happened in 1982, except the forces at work in 2012-2014 will be occurring outside our borders.

B. Impact on Investment Decisions: Unless the objective is end up in fifteen years about where you started with your investments, it is clear that buy and hold is not a viable strategy during a long term bear market cycle.

Possibly, an investor needs to try an identify the possible onset of a long term bear market as situational risks increase for that investor. Those risks include using stocks as a source of income during retirement or to pay major expenses such as a college education for your children. But, I would say that it behooves all investors to make the best judgment possible on this issue.

During a long term bull market, buying and holding stock index funds, reinvesting the dividends, would be a defensible approach and probably the most sensible one. It would probably not be a good idea for individuals to try and time the market during that long term bull market, recognizing that the bear corrections will be relatively short in duration and difficult to time anyway by moving out before they occur and back in before the market resumes its long term secular uptrend.

One helpful marker is simply the duration of the long term bull market. After fifteen years of a long term bull market, it is probably best to become cautious about stocks and to look around really hard and seriously for potential problems that could undermine the continuation of the uptrend. But, let's say hypothetically speaking, that the investor saw problems in 1997 and sold at least some of the S & P 500 index bought on 1/1/1982. The non-inflation adjusted return with dividend reinvested would have been approximately 17.91% annualized or 14% after inflation. That works for me. Now the inflation adjusted return from 1/1/1998 through 12/31/2008 would have been - 1.44%.

While many will disagree, including all those who adhere to the recommendations of Siegel and Bogle, I think that it is possible to maintain a stock allocation during the long term bear market, but a more dynamic trading process has to be used to significantly reduce the stock position during the short term cyclical bull moves and to reposition the portfolio by buying during the short term bear cycles, particularly during the catastrophic phase of the bear market where longer term stock positions can be acquired and held for the long term (i.e. summer of 1974 or 1932, early 2009). That means that cash has to be on the sidelines during such a period.

Also, it is important to identify which asset classes will likely hold or increase their value during the bear phase, and which will run with stocks, both up and down. What asset classes will be highly positively correlated with stocks and which will be negatively correlated or have low positive correlations? During the cyclical bull move starting in March 2009, commodities, foreign currencies like the Australian Dollar and the Canadian Dollar, and emerging markets have had a high positive correlation, at least until mid January 2010, and this was also true during the down period for stocks between September 2008 to March 2009.

My Vix Asset Allocation Model is primarily a timing tool for reducing stock exposure during a cyclical bull move after the occurrence of a Trigger Event. The cyclical bull move which ended in October 2007 was preceded by a Trigger Event in August 2007: VIX Chart from 2007: Alerts and Triggers Major Disruption of Cyclical Stable Bull VIX Pattern Vix Asset Allocation Model Explained Simply With as Few Words as Possible The model also flashed a Trigger Event prior to the 1987 crash: Parallels to VXO 1987-1988 It gave a green signal in early 1991 and did not have a Trigger Event until 1997. More on VIX AND ASSET ALLOCATION VIX and S & P Compared 1990 to 1997 A green light was then given in 2003 until the trigger event in August 2007: Multiple Confirmations of VIX Model-Canary in a Coal Mine

I did reduce stock exposure in 2007 in response to the signal given, and repositioned those funds into bonds and cash. (e.g. discussion in October 2008 Post: Buy High & Sell Low /Retrospective on the Good & Bad). I redeployed some funds back into stocks during the catastrophic phase of the cyclical bear cycle in March 2009, as discussed in numerous posts from March and April 2009: Stocks & Politics: March 2009 Stocks & Politics: April 2009

I would have to say that it is far, far more difficult to stay ahead in a long term bear market. Any fool can make large percentage returns on capital by buying an index fund during the long term secular bull market.It is not difficult to make money during such a period unless the investor wants to create problems for themselves by churning. The difficult environment is when the process has to become dynamic and complex, if the objective is to advance your capital position, with a lot of shifts out of and between carefully chosen asset classes.

During any long term cycle, other asset classes may present significant buying or selling opportunities. A recent example was the opportunity to buy investment grade corporate bonds starting in late 2008 and early 2009, at unusually large spreads to comparable treasuries, which was heightened in the niche market for Trust Certificates: Trust Certificate Links in One Post An asset class undergoing a parabolic move, such as oil on its way to $150 a barrel, would be an example of something that needs to be sold, irrespective of the classification of the long term trend.

Since I am currently 58 years old, and presently doing well in my second long term secular bear market of my life, I suspect that I will have just one more long term secular bull market where I can relax and coast, and unfortunately one more long term bear, which may be really nasty. In the next bear period, the asset classes which might be negatively correlated with stocks may be different than the ones which worked in the current long term bear. I would be surprised if treasury bonds held up during that period, possibly starting around 2027 to 2030 and lasting until a large number of baby boomers pass away.

2. Australian Dollar and the Carry Trade: In several posts I have discussed the role of the Australian dollar in the carry trade. An article in weekend WSJ discusses this issue an highlights how the unwinding of a carry trade can place downward pressure on the Australian currency. Basically, money is borrowed in low interest rate currencies, which historically would mean the Japanese Yen and currently includes the U.S. dollar, and invested in high interest rate currencies which would include the Australian dollar. The speculator would use extreme leverage, perhaps as much as 500 to 1, to increase the arbitrage between the two interest rates. When the carry trade involves the U.S. dollar as the funding source, with the money parked in Australian dollars, the unwinding of that trade requires selling the Australian dollar to buy U.S. dollars to pay back the loan, and this places downward pressure on the Australian dollar. US Dollar and the Carry Trade I mentioned this phenomenon in a post from October 2008: Weekend News 10/ 25-26/ 2008 Recognizing the implications, I had already sold my position in the Australian dollar, except for 30 shares of FXA, a currency position that had been bought and sold in 2008 as one of my more profitable trading strategies during that awful year. I recently sold that 30 shares of FXA at $91.62 based in part on a belief, more appropriately described as a hunch, that the same unwinding process was under way: Item # 6 /Australian Currency At some point, I want to buy FXA back, just not anytime soon.

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