Scarcity creates value, and scarce behavior, in the investment
markets, creates value. We have repeated John Maynard Keynes' great
quote many times, but as an introduction to our topic today, it
must be said:
"Investing is the one sphere of life and activity where
victory, security and success is always to the minority and
never to the majority".
What created the circumstances we have today where financial
advisors, registered investment advisors, consulting firms, and
institutional investors are pursuing the same basic asset
allocation format? We believe it can be laid at the feet of the
massiveU.S. equity bubble of 1999. Most of the risk capital in the
world came to be concentrated in the 50 largest-capitalization
technology stocks and 90% of these companies were in theU.S..
Massive money flows came into the S&P 500 Index through mutual
funds. Most of those flows came into large-capU.S. equity funds. In
an effort to diversify away from ridiculously over-priced tech
stocks, veteran large-cap growth stock managers moved into
large-cap growth staples and ran them up to 40-50 PE multiples. In
the process, the S&P 500 Index became massively over-valued.
The "nightmare" in theU.S. stock market was created by
over-concentration in an over-priced stock market.
While that sector flourished in a runaway bubble, all other
asset classes were starved for capital. There was only money for
tech and large growth. There were no small cap tech stocks in 1999
and small cap was dying for capital. Capital-intensive value
portfolios didn't own tech and they were starved.
The Federal Reserve was tightening credit in 1999 to try to slow
the economic boom that went with the tech bubble. The credit
tightening caused bonds to be deeply out of favor. They had no
ability to compete with the stock market, which had gained more
than 20% per year on average over the prior 5 years. No other
country in the world had a concentration of major tech companies,
therefore, international and emerging markets were starved for
capital. They had just been hit by the "Asian Contagion" and
Long-Term Capital Management debacles of 1997-98. Oil was $11 per
barrel at its low in 1999. Commodities had been in a bear market
since 1981. Manufacturing companies were squeezed by higher
interest rates and a lack of demand from commodity-oriented
countries and companies. Every other asset class and stock market
sector was having its oxygen (capital) sucked up by the tech stock
tri-athletes who were running the most spectacular race theU.S.
stock market had ever seen.
When the tech bubble burst, a great deal of capital was
destroyed. Some major part of what was pulled out in theU.S.
tech-driven stock bubble began to be moved into other asset
classes. First, it went into bonds. Ten-year Treasuries were at 6%
in 1999-2000 and rates bottomed in late 2008 at 2%. Gold was close
to $200 per ounce and major world governments dumped their
long-time gold holdings. Emerging markets, which started out with
tiny stock market capitalizations, began to explode as a small part
of what was in tech stocks was an enormous amount of new money.
Commodities began to catch a bid in 2003 and by February 2011 had
produced the best ten-year rolling return inU.S. commodity trading
history. Small-capU.S. portfolios clobbered their large-cap
brethren over the last ten years.
Former Merrill Lynch Strategist Richard Bernstein has talked
about "investing like the Mafia". He argues that the Mafia invests
in areas that nobody else wants to touch and demands extremely
favorable results in return. The Mafia does that by going into
areas where capital is scarce due to illegality. There is nothing
stopping us from doing the same thing in legal stock sectors or
What created "nirvana" was that early asset allocators, who
widely diversified, ended up with above-average returns and they
got it by taking below-average risk. The risk was below average
because their behavior was scarce. I've explained this before using
a horse racing analogy. Let's say there are 10 horses in a race. If
I bet $2 to win on every horse in the race, I can only make money
if a horse carrying 10-1 (or better) odds wins the race. From the
year 2000 to today, an unusually large number of the asset classes
with greater than 10-1 odds won the race. Almost every other asset
class besidesU.S. large-cap began the race at 10-1 odds or better
and most of them were more like 30-1 to 90-1 odds.
Once those who were early adopters of wide asset allocation
began to have outsized success, they began to draw a great deal of
attention. The folks running the endowments of Harvard and Yale
were in a position to do this and were wise enough to execute the
scarce behavior. Investment firms, consultants, RIA firms and
financial advisors quickly fell into place behind them between 2005
and 2008. The flow of money came out of large-capU.S. stocks and
stock funds and was spread across these asset classes which had
been starved for capital. In many cases, these asset classes were
incapable of handling that much money without running up in price
so much that they became a bubble market on their own.
When the tech bubble was in its go-go years, Wall Street found a
number of new companies and new ways to pursue the tech agenda. The
same is now true for wide asset allocation. Bloomberg had an
article on June 8th, 2011 which explained how advisory firms are
using Exchange-Traded Funds (ETFs) to execute their wide asset
allocation strategies at the expense of using equity mutual funds.
These lower-cost vehicles allow money managers to "move around"
more easily, based on their macro-economic outlook among asset
classes or stock/bond sectors. They seek to offset a part of the
expense they charge investors for selecting which asset classes to
over-weight or under-weight. The article explained this through a
quote from Scott Burns, the head of ETF research at Morningstar,
who said, "There's a shift going on from seeking outperformance on
an individual-company basis to seeking it on a macro basis." I hate
to be the person that tells this to Scott, but the shift has been
going on since the end of 1999. My favorite quote on this subject
comes from investing great, Peter Lynch, who said, "I spend about
15 minutes a year on economic analysis. The way you lose money in
the stock market is to start off with an economic picture."
How does wide asset allocation become a "nightmare"? It is
simple. Almost every horse in the race has so many bets placed on
them that they trade much closer to 2-1 odds than 10-1. In other
words, diversifying by asset class to reduce risk is impossible
because there appears to be only one horse in the race, which is
starved of capital. We believe the Mafia would only consider
large-capU.S. and they would only look at those large-cap funds who
are avoiding oil, basic materials and heavy industrial companies.
Those are the only S&P Index subsectors which succeeded during
the last ten years and are trading at the highest price-to-book
value ratios they have traded for in the last 25 years. Those
subsectors are at no better than 2-1 odds, in our opinion.
We believe the next 10 years will be about money moving back
into non-cyclicalU.S. large cap stocks and domestic companies which
enjoy lower commodity prices and the repatriation of money from
"highly" risky asset classes with poor odds. We have placed our
bets and are excited about the race that is set to begin. Being
widely asset allocated today prepares folks for an
under-performance "nightmare". In our opinion, bonds are expensive,
commodities are outlandish, small caps trade at a huge premium and
as China's economic contraction occurs, the crowd will flee
emerging markets. Scarce behavior today means buying and
holdingU.S. large cap stocks that meet our eight criteria, and
avoiding any of the stock market sectors that are open to being
part of that "nightmare".
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours.
Unit Sales in the Apple Industrial Era