PIMCO Said Economy Returns To The ‘Old Normal’, Should Our Investments Too?

According to Bloomberg, PIMCO now believes that the economy returns to the ‘old normal’ from their touted ‘new normal’. What that implies is that U.S. economy is back to a classic expansion that will garner about 3 percent annual growth. Furthermore, it signifies that we will see a normal growth and bust economic cycle instead of a secular stagnation punctuated with a few (serious) downturns. 

From time to time, investors hear or read such a significant prediction/forecast. They are often confused: some start to change their investment strategies, some start to dabble into the favorable segments ‘bravely’ and some completely abandon their risk management methodology and start to speculate.

In this newsletter, we would like to take this as an example and go through a few items to clarify how we, as normal investors, handle such news or reports. 

Economy is not the same as the financial market

First, financial markets only keep track of economy in a long term fashion. In a short term, the two do not necessarily agree with each other. In fact, often financial markets try to predict future economy. Very often, current financial market has incorporated much future information in its valuation and behavior. 

For example, stock markets often recover strongly when the economy is in a very dire state. That is because markets begin to sense the economy has bottomed and market participants have tried (maybe with several ‘fake’ rallies already) to position their investments or speculative bets accordingly. 

Similarly, stocks often start to decline even when overall earnings are at the peak. Again, when stock valuation reaches a very high level that is out of norm, a correction/downturn can happen to bring the valuation back to a normal level, the so called ‘regression to the mean’. 

At the moment, stock market valuation is at its historical high, based on various long term metrics: 

• Warren Buffett Total Stock Market Value to GNP Ratio is 129%. 
• Shiller Cyclically Adjusted PE 10 Stock Market or the ratio of Real Price to the average of last 10 year Real Earnings(CAPE10) is 1.55. US stock market is 55% over valued. 
• Hussman Peak PE Market  or the ratio of Real Price to the average of last 10 year Peak Real Earnings is 1.52. US stock market is 52% over valued. 

See Market Indicators for more details. 

Regardless of whether the economy returns to the old normal or not, current stock market is richly valued. 

Predictions often fail: do you have a solid plan to cope with them?

Furthermore, even if you believe that economy is tightly coupled with financial markets, you should be aware that any statement about future is just a forecast or a guess. What that means is that such a prediction/forecast can fail (and they do often). So the question is whether your investments (portfolios) are positioned to handle such failures. 

For example, PIMCO first made its ‘new normal’ theory in 2009. Since then, the U.S. Real GDP has grown at an annual average 2.2%. During the time, due to the excessive Federal Reserve’s loose monetary policy, stock markets have rallied. 

Data source: U.S. Bureau of Economic Analysis. 

Along the way, PIMCO has made various mistakes in its investment thesis. Among them are the various erroneous bets made by Bill Gross (the manager of the world largest bond fund PIMCO Total Return Bond Fund). Because of these bets, the PIMCO Total Return Bond Fund has had a lousy return, under performed its category average in the last 1 and 3 year time frame. This has caused a large capital outflow from the fund. 

Similarly, Hussman’s Strategic Growth Fund (HSGFX) has also suffered. Hussman was a firm believer that the economy was in a recession from later part of 2012 to 2013, resulting in a overly conservative hedge that costed the fund returns. 

The above by no means criticizes Bill Gross and John Hussman. Everyone makes mistake. It is the fact of life that no one can predict the future. On the contrary, great investors usually bounce back. What we try to show here is that even the best can make mistakes, and they make mistakes often too. 

As what we have repeatedly pointed out, the key here is not about the mistakes but instead how one’s investments can cope with the mistakes. For us, that means investors need to check two things:

• Do your portfolios have excessive risk exposure that can inflict severe or hard to impaired damages? 
• Do you plan out these downturns beforehand and respond accordingly or you just handle them as they come with some random hunches?

The first factor is about the maximum risk tolerance, this can be both psychological or economical one. Often investors have much short term memory (or imagination). When markets are good, the severe market downturns can be either too hard to overcome, resulting in under investment in early stages of recovery but eventually joining the party at a very late stage; or the severity of these downturns can be too hard to remember or imagine, resulting in over investment that eventually damages their portfolios. 

The second factor is very much related to the first but is also about investment plans or strategies. A random reaction is the receipt for failure.

Strategic allocation for a long term

If you believe that in a long term, a financial market as a whole will correctly reflect the basic capitalism principle that awards surviving businesses with so called risk premium, a excessive rate of returns over risk free cash due to their enterprise business risk taking, you will also agree that it is a sound strategy to have part of your investments that you set aside for a long time to invest in a diversified array of funds that again invest in a market segment in a diversified manner (such as market index funds). 

A Strategic Asset Allocation gives you a solid framework to deal with market and/or economic cycle changes such as the ‘new normal’ to ‘old normal’ prediction (or reality). Diversification and periodic rebalances allow you to withstand many unforeseen events. As long as the investments in various asset classes deliver the expected returns in a long period, such portfolios will carry you through all of these noises and/or gyrations. 

As what we stated elsewhere in July 29, 2013: Strategic Asset Allocation: The Good, The Bad And The Ugly, strategic portfolios have many advantages such as less error prone and tax efficient. However, one should also be aware such a strategy is only suitable for a long term portfolio.

We think it is very beneficial and interesting to use a conservative method proposed by Hussman (see his latest commentary). In this method, asset allocation is determined using liability driven method that is often used in pension funds. He uses dividend stream as the cash flow in a long term portfolio, similar to a fixed income (bond). Roughly, given the current S&P 500’s 2% annual dividend rate, that would mean a 100% in (S&P 500) equity portfolio would have a 50 year duration while a 60% equity portfolio would have 50*0.6=30 year duration. Using such  a conservative liability driven method, it would mean even the ‘baseline’ moderate portfolios listed on MyPlanIQ (60% risk assets or 40 risk profile) should be only used for investments that are expected to be only used in 30 years!

Though the above  dividend as cash flow liability approach might seem to be overly conservative, at any rate, investors should be aware of the possible severe loss in a strategic portfolio and plan that accordingly. 

Tactical allocation for short and intermediate term 

However, in reality, many investors need to tap into their investments in a much shorter period. Furthermore, many can not withstand the severe loss in their majority of investments in strategic portfolios.  Tactical allocation strategies such as MyPlanIQ’s Tactical Asset Allocation (TAA) can be used for such a purpose. 

We have written much on our tactical strategy, which is a trend following strategy over a diversified array of major asset classes. Our previous newsletter July 22, 2013: Tactical Asset Allocation: The Good, The Bad And The Ugly discussed some of its major pros and cons. We also have devoted several newsletters to discuss how such a strategy has performed in the past 20 years or even longer period and how it behaved in various market cycles. See our newsletter collection for the list of articles. 

If we review the performance of the TAA in the post financial crisis (2008 to 2009) period, we can see that it delivers some reasonable returns (as of 4/28/2014): 

**YTD: Year to Date

The 5 year chart

Year by year detailed link >>

The three representative ETF TAA portfolios (listed on our brokerage portfolios page) have actually delivered respectable annual returns even in the last 5 year time frame. In fact, they are very comparable with the strategic allocation portfolio that can serve as a  benchmark. Even though they under performed the extreme 60% US stocks and 40% US bonds portfolio (Vanguard Balanced Index Fund VBINX), these portfolios’ returns have been reasonable. 

Our TAA has delivered what we intend it to do: at a good time, it delivers a reasonable, market comparable returns (or even slightly lower returns) while at a bad time, it preserves capital. By doing so, such portfolios have much lower risk and smooth out returns (thus better suited for practical needs). 

Regarding how TAA would handle the switch from the ‘new normal’ to the ‘old normal’, we would expect it continues to do its job: understand major market segments’ trends (or major asset classes’ trends) and follow them in a reasonable diversified manner. Just as what we have seen from the past several years, if the economy continues to expand and the financial markets continue to rise (due to various reasons including bubble chasing, solid fundamentals for yet a couple of years etc. ), we expect our TAA will ride on risk assets and achieve good returns as the risk assets will do. However, if the new to old normal prediction turns out to be false or financial markets suffer, we expect the TAA will carry us through this period by shunning the losing assets, thus avoiding major loss (barring  a 1987 style stock market crash, see our discussion in October 28, 2013: What Can We Learn From The 1987 Stock Market Crash?)

To summarize, the above exercise is to examine how one should handle or respond to a sensational news such as the PIMCO’s new normal to old normal in their investment portfolios. To some extent, these types of predictions are very much irrelevant if you have a sound and well planned investment strategy in place. 

Market Overview

We are now about to enter May, a month that is prominently featured in ‘Sell in May and go away’ adage (see Sell in May and Go Away Seasonal Timing on Advanced Strategies page). Emerging market Stocks have retreated back to negative trend territory. Other major risk asset classes are still hanging in their elevated levels.  Investors are still showing appetite for risk assets. Given the earnings season is underway, we will stay on course and let markets decide.

For more detailed asset trend scores, please refer to 360° Market Overview.

We would like to remind our readers that markets are more precarious now than other times in the last 5 years. It is a good time and imperative to adjust to a risk level you are comfortable with right now.  However, recognizing our deficiency to predict the markets, we will stay on course. 

We again copy our position statements (from previous newsletters): 

Our position has not changed: We still maintain our cautious attitude to the recent stock market strength. Again, we have not seen any meaningful or substantial structural change in the U.S., European and emerging market economies. However, we will let markets sort this out and will try to take advantage over its irrational behavior if it is possible. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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