Disclosure: Dan is long OSM, ADX, APF, IDE, ETJ, UTF and short MTS.
A risk-averse approach to wealth today demands greater acceptance of what are traditionally “risk assets”. A historically significant rally may be approaching as effective risk tolerance normalizes.
I believe to be observing something significant in the broad marketplace, which compels a vocal macro contribution. Specifically, I believing that upside risks exceed downside risks, substantially. There is a significant possibility of a dramatic upward move in asset prices in no small way related to the probability of significantly negative real returns (interest rate less inflation) for sidelines wealth.
A logical approach to Risk
All choices of what to do with money involve risks. If one hides their money under a mattress, they risk inflation, declining value of the dollar, theft, their house burning down, and the forgetful symptom of dementia. The example of extreme paranoia may demonstrate the irrationality of believing in the concept of risk-free in a way that, for most, is not too close to home. Sadly, “Joe Public” commonly thinks about rolling CDs as risk-free, and institutions commonly look at rolling T-Bills the same way. Whether its CDs, savings accounts, money market funds, or fad-laden short term treasury ETFs, these perceived risk-free assets have supported a valid risk avoidance strategy of treading water. But now, policy makers have deemed them a guaranteed mechanism to lose buying power for the foreseeable future.
QE2 shows the Fed is committed to avoiding deflation, ushering a weak dollar and inflation irrespective of public opinion. If sidelines wealth, a historical anomaly in size, proves disinterested in a probable loss of buying power, it has two logical alternatives. Spend wealth or buy risk assets.
So does spending stimulate the economy, or does investor tolerance for traditional risk assets regress to the mean, and then pass the mean in market-customary form? My best guess is that sidelines wealth will offer a split decision, so both.
The Power of the Dramatic Move
With my undergraduate degree’s wetness still behind my ears, I was a retail financial advisor in the late 1990s. For those that don’t know (at the time I didn’t) the financial advisor is the investment industry’s salesman, the asset gatherer. We were encouraged to pitch prudent investing as “Not Timing the Market, Time In the Market.” Historical broad market performance to that era had provided for illustrious charts. Our employers armed us with those charts to sell the Time In the Market catch phrase.
What once truly powered the Time in the Market story for asset gatherers (financial advisors) was certainly not any inconsequential nature of history’s dramatic short term negative moves. The power which validated the sales pitch came from the historical importance of being invested during dramatic short term positive swings. The lost decade of the 2000s altered the historical return adequacy of the Time In the Market pitch, so the asset gatherers’ now pitch what sells. Ironically, the relevance of the dramatic short term positive swings that once powered the Time In the Market pitch appears vital to prudent financial planning today.
Risk is too frequently contemplated only in the narrow context of a directionally downward market. However, it is foolish than anyone not be similarly cognizant of upward risks, particularly with policy makers and QE2 poised to extend and dramatically magnify the public’s frustration with the “risk-free” real returns. The US government itself has risked broad worldwide disenchantment with its own balance sheet to force its people and its business into a historically consistent level of risk tolerance. In my view this event should be contemplated in the context of sidelines wealth having previously amassed with risk aversion, but lacked an impetus to reenter risk assets.
Objectivity is Paramount to Ego
Buying at higher prices is painful to those of us who believe to be price-disciplined. Objectivity demands that when appropriate, I accept pain. All who were underinvested over the last couple months will find no retribution, and I will admit having been in their company. As unheralded the trait of modesty is on Wall Street, it is imperative to objective decision making, and ongoing learning through self reflection. In late August, I came to a large cash allocation. Mr. Market and hindsight agree in negatively grading my inaction — my failure to meaningfully invest the proceeds received from an involuntary SKMRX liquidation at that time. My recent personal underperformance is indicative of the consequences.
I think my lack of upside conviction was well-founded in risk-aversion at the time. The market looked particularly “confused” prior to the rally that began in September. There were upside and downside risks, and well-merited rationales for each. Many of the positives hold true today. Stocks were cheap relative to alternatives, and perhaps under-owned. At the same time, economic policy makers had seemingly used their primary ammunition. They seemed focused on rhetoric, a troubling tactic to discourage the shunning of risk-assets.
Through most of October, I had concerns of the market consequences should expectations of QE2 prove an over hyped product of aggressive policy stewarding rhetoric. Until QE2 was announced and the broad market broke resistance (excuse the technician-speak) rather than selling the news, I remained interested in being under-exposed to risk assets. But as much as my approach to risk and my choice of investing mechanisms may differ from most equity traders, I find myself in the recently popular bullish camp. The rational time to tread water appears to have passed.
Risk Never Dies
It will never be possible to anticipate all downside risks to the market. I am particularly mindful of the risk that equity risk profile’s prospective returns may be less attractive when contemplated in the context of higher applicable future taxes. It seems a more widely held, but perhaps lesser risk to the prospect of insufficient or negative long term real returns in so called “risk free” assets. Even the seemingly risk-averse TIPS are unlikely to adequately compensate for the difference between the Consumer Price Index data and actual inflation.
I have a lesser distaste for portfolio beta than usual, but in risk-aversion I continue to view Beta as a risk in which I should avoid excess. All risks when focused lead to distasteful volatility.
Among exchange traded risk assets, I continue to like higher liquidation preferences on the corporate balance sheets I am investing in, particularly those whose dynamic yields may be poised to benefit from QE2. SLM Series A CPI Linked Notes due in 2017 (OSM) although thinly traded is among my favorite holdings in the account licensed to Covestor’s Taxable Income model. Among taxable income options I am also showing a preference to the bond-like attributes of Trust Preferred Securities not directly subject to any changes in Dividend Tax Rates. But many have significant call risk to avoid.
I continue to find long term reason to own the same 16 Master Limited Parterships (“MLPs”) for a very long time in the account licensed to Covestor’s MLP Direct Ownership Model. Never, and particularly not when expecting positive market returns would I want to alternately have my account’s MLP allocation in a C-Corporation wrappers (ie: ETF/Closed-End Funds).
I am increasingly willing to own some international assets and high beta underfollowed securities like Morgan Stanley Asia Pacific Fund (APF) particularly when fitting into a high conviction thesis. APF is among my holdings in the account licensed to Covestor’s Well Intentioned Activism Profile Closed-End Funds model.
My largest equity asset class longs in the long-only account licensed to Covestor’s Core Total Return Model and in the Long/Short account licensed to Covestor’s Long/Short Opportunistic Model are Closed-End Funds IDE and ETJ respectively which are favorite subjects of a tax-themed thesis going into 2011. Obviously, I continue to be interested in the short-selling style, although my accounts that feature short positions are only a small component of my overall strategy. The account licensed to Long/Short Opportunist has recently gone long Adams Express (ADX) and Cohen & Steers Infrastructure Fund (UTF), and closed a short position in DNP Select Income (DNP). The account licensed to Pure Short Opportunistic has nothing but short positions. My favorite short position there right now is Montgomery Street Income Securities (MTS) which is an income fund which recently sliced (link) the income on a reasonably astute shareholder base. Short Selling will always remain one important thing that I do because of a desire to be exposed to alternate risks, in alternate concentrations, in alternate accounts. A macro call can be wrong and I must not be overconfident or overexposed.
If I wasn’t content with the risk-reward profile of risk assets today, I would be aggressively spending.
The above text is licensed to Covestor Ltd. (“Covestor”), by Dan Plettner. Such text may be disseminated only by Covestor. Dan Plettner invests and receives income for securities research, including “buy-side” research. Dan licenses his own real time trading data to Covestor Ltd. (“Covestor”). Covestor is a Registered Investment Advisor that uses Dan Plettner’s data to create the Core, Activism Profile Closed-End Funds, Long Short Opportunistic, Pure Short Opportunistic, Tax Advantaged Income, Taxable Income, and MLP Direct Ownership models for its clients.
