Investing in Uncertain Markets

Investing in Uncertain Markets Don Lansing AAII Baton Rouge Chapter Meeting October 6, 2012

Don Lansing (donl@stedwards.edu)

At the highest level, we value assets with this formula: Cash Flow/Risk = Asset Value Don Lansing (donl@stedwards.edu)

What Drives Market Prices? • Fundamentals Economic Cycle; Corporate Earnings (S&P 500 at $100/share in earnings) • Investor Sentiment  Enthusiasm drives P/E ratios for stocks; Yield spreads for bonds • Liquidity Availability of capital; money flow; Fed policy can influence this (HAS influenced this!) Don Lansing (donl@stedwards.edu)

Corporate Earnings x PE Ratio = Market Prices Don Lansing (donl@stedwards.edu)

Market Cycles • Most stocks follow the market • Markets move in broad cycles driven by a combination of fundamentals and sentiment • SECULAR cycles last 15-20 years, typically • Sub-cycles last 2-3 years, typically • Secular cycles peak when investor sentiment (good or bad) reaches a “fever pitch” pushing prices well beyond norms. • Sub-cycles change more on events/fundamentals – e.g. perceived economic expansion/recession Don Lansing (donl@stedwards.edu)

Secular Market Cycles • Secular bull cycle – i.e. 1982-2000 for stocks • Investment rarely loses money • Pricing reaches very high levels • P/E ratios for stocks are a good general barometer • Secular bear cycle – i.e. 2000-today for stocks • Investment struggles to deliver real return • P/E ratios gradually slope downward to under 10 Don Lansing (donl@stedwards.edu)

Market Cycles • Global finance and economics becoming increasingly intertwined • Increased systematic risk • Domestic cycle influenced by global cycle, but still distinct • Europe in recession • China Slowdown  falling commodity demand  weakness in Brazil, Australia, Russia, other EmMkts • These areas are in a clear bear market • U.S. growth sluggish but best of neighborhood Don Lansing (donl@stedwards.edu)

The Impact of Global Debt • Living in Reinhart/Rogoff World: • Research by Reinhart/Rogoff widely sited for concerns about U.S. debt • Studied financial situation of 44 countries over two centuries • Found that debt to GDP >90% was a tipping point • Led to reduction in growth of -1% for years on end (20+ years) • Why? Limits government’s ability to invest • Resources going to pay down/support debt • Interest rates spike as markets demand more compensation Don Lansing (donl@stedwards.edu)

The Impact of Global Debt • Is the U.S. different? • Yes – for now. • Almost unlimited ability to borrow, and very cheaply! • Reserve currency and related Treasury bond market provide important “buffer” – size of markets without peer • Debt has been transferred from private to public – lowers net interest expense in the “system” • Debt supporting investment is preferential to debt supporting consumption – “hello Greece” • It gives us the “freedom to be irresponsible” Don Lansing (donl@stedwards.edu)

U.S. Budget “fiscal cliff” • Upcoming “fiscal cliff” discussions could create substantial market uncertainty  increasing volatility and risk • Investment community believes: • A deal will be struck to smooth out impact of tax/spend changes • Sometime between late 2012 and 1Q 2013 • Election has bearing on which areas are most targeted, but impact may be limited • Any related selloff in dividend stocks should be a good buying opportunity Don Lansing (donl@stedwards.edu)

Corporate Earnings x PE Ratio = Market Prices BULLS: • PE Ratios are cheap, especially with interest rates so low. • The worst has passed and the future is brighter than the past. BEARS: • The global economy is buried under the weight of debt • Deleveraging (reducing the debt) cycle will keep earnings and investor sentiment down • Eurozone workoutsand China slowdown are big known risks. • U.S. budget issues and related debt are a big potential risk. Don Lansing (donl@stedwards.edu)

Building an Investment Strategy • Objectives • Long-term (retirement) vs Short-term (project) • Personality Profile • Knowledge • Maintenance • Stomach (Ability to Handle Volatility) Don Lansing (donl@stedwards.edu)

Discussion of Risk • What is risk? A result that is different than expected – investors focus on worse than expected. • Volatility is the enemy of successful investing (though it also creates opportunities) • Deviation is dangerous because it pushes emotional buttons in individual investors  makes them anxious, induces fear, … • Deviation from account peak – what we call “drawdown” – is a key focus • Investors emotionally “own” an asset value • Thus, the goal is to minimize drawdown and hold on to the bulk of gains offered

2-3 Years Up; 1-2 years Down Don Lansing (donl@stedwards.edu)

Dealing with Uncertainty:Permanent Portfolio • Established in 1982, in an era of stagnant economic growth and rampant inflation, Permanent Portfolio seeks to provide a sound structure and disciplined approach to asset allocation. The Fund was born in an environment where investors didn't know where to turn. Regardless of what an investor did, they were losing money. Harry Browne, one of the founders of the fund stated, "It's easy to think you know what the future holds, but the future invariably contradicts our expectations. Over and over again we are proven wrong when we bet too much on our expectations. Uncertainty is a fact of life."No one can accurately predict the future. Don Lansing (donl@stedwards.edu)

Dealing with Uncertainty:Permanent Portfolio • Solution: Invest in 4 uncorrelated asset classes • Precious metals, cash, stocks, U.S. Treasury bonds • Fund (PRPFX) got off to a bad start, losing over -10% in its second year • Has since lost money 3 times in almost 30 years • Expanded charter to include non-U.S. stocks and real estate Don Lansing (donl@stedwards.edu)

Permanent Portfolio – Slow Start, Good Decade Don Lansing (donl@stedwards.edu)

Permanent Portfolio – Flat Year Don Lansing (donl@stedwards.edu)

Dealing with Uncertainty:Low Volatility Investing • Another reaction to secular bear market ending in 1982 • Study shows that buying and holding low-volatility stocks = market return with 2/3 the volatility. • Calls into question fundamental tenet of investing research • One is compensated more for taking more risk • Recent: S&P creates a low-volatility index  SPLV Don Lansing (donl@stedwards.edu)

Dealing with Uncertainty:Setting volatility targets • Rather than focus on return, focus on measuring and adjusting portfolio based on market volatility • Set target volatility – example 15% • Divided Volatility Target by S&P Volatility • Result sets % allocated to equities • As market volatility increases, equity allocation decreases • Ex: 15% / 20% = ¾ = 75% equity allocation Don Lansing (donl@stedwards.edu)

Dealing with uncertainty – simple timing

Dealing with Uncertainty:Portfolio Construction – Combining ideas • Carry a low-volatility core portfolio • Can be low-volatility stocks and/or bonds • Bonds can be adjusted for risk target – e.g. HY • “Allow” allocation to higher performance/volatility pieces when applicable • When market trending up – own higher-beta pieces • Market volatility increases – cut high-beta positions Don Lansing (donl@stedwards.edu)

Combining Low Vol + Simple Timing Don Lansing (donl@stedwards.edu)

Avoid the bad times. Keep vol low. Don Lansing (donl@stedwards.edu)

Down/Upshifting a Portfolio • We can also take half-steps in making our portfolio more tactical • Reduce our risk by adding more yield • Move from stock index position to • High yield stock ETF (DVY/SDY or HDV) • Preferred stock ETF (PFF/PGX/PGF) • Note: mostly financial companies • Hybrid yield ETF (PCEF/INKM) • High yield bonds (HYG/JNK, VWEHX) • Corporate bonds (LQD) Decreasing Risk Don Lansing (donl@stedwards.edu)

Managing Income Portfolios • Relative versus Absolute Risk • Importance of Duration • +1% move in interest rates = -D% move in bond price • Managing spreads instead of rates • Spread = Difference between rate of bond & Treasury rate • Higher the spread, the more compensation being demanded • Lower spreads = nearer to end of cycle Don Lansing (donl@stedwards.edu)

To Summarize • Understanding where we are in broad market cycles helps frame our investment strategy. • Investors have been given new tools to manage portfolios based on risk/volatility. • Volatility likely to increase over next 12 months as U.S. “fiscal cliff” becomes focus • Europe and China remain uncertain with difficult passages ahead • But we are building to a rich period for stock investors – it’s just getting there that’s painful! • There are ways to substantially lessen volatility while still achieving solid returns. Don Lansing (donl@stedwards.edu)

Be LONG insanity and SHORT common sense - @parhedge Don Lansing (donl@stedwards.edu)

THANK YOU BATON ROUGE! Don Lansing (donl@stedwards.edu)

Investing in Uncertain Markets