Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
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.___________________________
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 33 years and has been published in Barron’s. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
“Current low valuations reward the long-term view”, an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). “Intelligent Individual Investor”, an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. “Benjamin Graham in Perspective”, an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, “Gold Coffin?” in Barron’s (March 23, 1998, Volume LXXVIII, No. 12, page 62) or “What Speculation?” in Barron’s (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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Revised: October 15, 2020 TAF
© Copyright 2020 Dennis C. Butler, All Rights Reserved