The Investor's Guide to Active Asset AllocationAllocation Using
Intermarket Technical Analysis
and ETFs to Trade the Markets
Martin J. Pring
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Dedication To my daughter, Laura.
Copyright © 2006 by Martin J. Pring. All rights reserved. Except as
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Contents
1. Some Basic Principles of Money Managements 1
2. The Business Cycle: Nothing More than a Seasonal Calendar
23
3. Useful Tools to Help Us Identify Trend Reversals 47
4. Putting Things into a Long-Term Perspective 73
5. How the Business Cycle Drives the Prices of Bonds, Stocks, and
Commodities 101
6. Say Hello to the Martin Pring’s Six Business Cycle Stages
123
7. How to Recognize the Stages Using Models 141
8. Identifying the Stages Using Market Action 171
9. How the Stages Can Be Recognized Using Easy-to-Follow Indicators
185
10. If You Can Manage the Risks, the Profits Will Take Care of
Themselves 201
11. How the 10 Market Sectors Fit into the Rotation Process
233
12. Sector Performance through the Six Stages 251
13. What Are Exchange Traded Funds? What Are Their Advantages?
275
14. How to Use ETFs in the Sector Rotation Process 295
15. ETFs and Other Vehicles as Hedges against Inflation and
Deflation 321
16. Putting It All Together: Suggested Portfolios for Each Stage in
the Cycle 335
Index 365
Introduction
Introduction The CD at the Back of This Book Strategic versus
Tactical Asset Allocation Why Do We Need to Allocate Assets? The
Seasonal Approach to Asset Allocation Investing Is as Much about
Psychology as Applying Knowledge
Introduction
Have you ever been in a situation where you were listening to a
business program on TV or reading a financial article in a
newspaper and were totally confused about how the people concerned
came to their conclu- sions? You probably heard comments such as,
“Well, Jack, I think the mar- ket is going up because consumers are
starting to get optimistic about the economy, corporations are
likely to spend more on plant and equipment, and” blah, blah, blah.
The analysis from such opinions is typically subjective, as the
view is based on stringing together a host of factors that the
person believes will affect the particular market in question. They
are confusing because they fail to offer a way in which you can use
this grab bag of ideas and facts to make forecasts at a later date.
To make matters worse, such opinions are rarely backed up by proof
that consumers are going to spend more, or even if they do, that
this relationship has worked in the past. Indeed, the pickup in
spending may already be factored into the stock mar- ket, which
almost always looks ahead. I call it mouthing from the hip. Take
the oil argument, for example. Lots of commentators will use the
rising price of oil as the basis on which to make a forecast of a
recession. “In the past we have had a recession whenever the price
of oil has risen by so and so.” Could it be that the recession was
really caused by the deflationary
v
effects of rising commodity prices in general, of which oil is just
one com- ponent? Chart I-1 shows that oil and the CRB Spot Raw
Industrials (a broad commodity measure that does not include oil)
often rise and fall in tan- dem. It is not a perfect correlation,
but it certainly illustrates the point that oil is not the only
suspect.
The explanation in this book comes at the subject from a totally
differ- ent angle. We will do our best to avoid such lose thinking
by establishing that there is, generally speaking, a certain degree
of order in the markets and the economy. We will show, for example,
that the business cycle goes through a set series of chronological
events or economic seasons. The cal- endar year moves through the
four seasons and each one has specific char- acteristics where it
is the best time in the year to carry out certain tasks. We
generally sew seeds in spring and harvest them in the summer or
fall. Rarely would we sew them in winter, for in most situations
they would be destroyed. The same is true for the business cycle.
There are specific times when you want to own lots of bonds and
income-producing assets and times when you should own commodities
or resource-based stocks instead. Our objective here is to explain
the characteristics of these “economic” seasons and to lay out some
techniques that can help us identify them. A
vi THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
Chart I-1 CRB Spot Raw Materials versus Spot Crude Oil (Source:
pring.com)
calendar tells us about the 12 months of the year and how they
fall. Our task here is to set up a framework for the economy and
financial markets so you can see where they fall. In effect you
will be provided with a road map that can be used as a basis for
allocating and rotating assets during the course of a typical
business cycle.
We know from historic records that the seasons begin with spring
and end with winter. Does that mean that every time we plant corn
in the spring that we are guaranteed to harvest it in late summer
or early fall? In the vast major- ity of cases the answer would be
yes. After all, if the probabilities of planting corn and
harvesting it were not favorable, it would not be planted in the
first place. However, in some years it is possible that drought or
other extreme weather conditions will severely affect the harvest,
in some extreme cases wip- ing it out altogether. The same can be
said of our seasonal approach to the markets. Most of the time this
methodology works. We can see this from the rates of return from
our barometers featured in Chapter 7. However, there are exceptions
where markets do not respond to the economic and monetary
environments in the traditional and expected way. A great example
occurred in 1968, when interest rates rallied at a time when the
economic con- ditions suggested otherwise. These exceptions are a
fact of life and develop with any methodology. However, we can
minimize the damage in two ways: First our approach uses an escape
hatch in the form of long-term trend- following indicators, just as
a fighter pilot has an ejection mechanism.
Second, during the course of the cycle, different financial assets
are going their separate ways and occasionally moving in tandem. We
can use ratios of some of these key relationships as cross-checks.
To site an obvious example, during the inflationary part of the
(four-year) business cycle, the ratio of commodities to bonds
should be rallying in favor of commodities; during the deflationary
part, bond prices should have the upper hand, and so forth. These
intermarket relationships are important to our approach because
they act as cross-checks against what the economic and monetary
indicators tell us should be happening. Remember, it is the markets
and the action of the markets that should have the final word. For
example, it’s possible to say that the law will protect you at a
pedestrian crossing, but if a car is heading straight for you, you
need to get out of the way. It’s no good being protected by a law
when you are dead! Consequently, if the economic and monetary
indicators are pointing in one direction and the market itself is
not respond- ing or confirming, we need to go with the market’s
decision because that is where our money is. It is certainly not
invested in the economic and mone- tary indicators. It is the
attitude of participants to the emerging fundamentals that take
precedence over the fundamentals themselves. If the fundamentals
were the only consideration, it would not be possible for market
bubbles or busts to exist because rational thought would
predominate. Bubbles and busts are irrational, as are market
participants from time to time.
Introduction vii
The process of pricing in markets is one in which people look ahead
and anticipate what is likely to happen. The hopes and fears of all
market par- ticipants, whether actual or potential, are reflected
in one thing and that is the price. People do not wait for things
to happen; they discount events and news ahead of time. This is how
we can account for the fact that a stock price declines after the
announcement of favorable earnings. In such situa- tions the good
news has already been discounted by the market and partic- ipants
are looking ahead at the next development. If it’s not so
favorable, the stock is sold and the price declines. Alternatively,
the earnings may be poor and the stock rallies. Often this is a
result of money managers knowing that a disappointment lies ahead.
Because they do not know the degree of disappointment, they
postpone their purchase until the bad news is out of the way. If it
is in the realm of reasonable expectations, they immediately buy
from a public that is eager to sell due to the “unexpected” bad
news.
In this book we are principally concerned with fixed-income
securities and equities. However, because new vehicles have
recently been introduced that allow smaller investors to
conveniently purchase broad baskets of com- modities and gold, this
is also a relevant area to pursue. We will also take a close look
at the vehicles that will help us achieve these goals, as well as
explain the workings of the business cycle and the investment
implications for specific phases. For the most part, these will be
the Exchange Traded Funds or ETFs. ETFs began to gain a following
at the start of the century. They have the look and feel of stocks
because they are listed on the major exchanges and are quoted and
traded on these exchanges on a daily basis. They are continually
being priced just like any other listed entity while the exchanges
are open. They differ from open-ended mutual funds, which are
valued only once a day. Most ETFs also pay dividends. However,
their claim to fame is that they are really a basket of specific
stocks that exactly replicate an index. This could be a measure of
the market like the S&P or a specific sector, such as energy,
financials, etc. These vehicles are also available for bonds, gold,
and non-U.S. stock indexes. In all there are over 200 vehicles and
the selection keeps growing every year. ETFs therefore represent a
quick, easy, and affordable method for owning a basket of
diversified secu- rities aimed at a specific index.
The CD at the Back of This Book
At the back of this book you will find a CD-ROM that contains a
substantial amount of information to supplement explanations given
in the book. Included are historical data files for some of the
economic, monetary, and market indexes described. The CD also
contains live Web site links so that the data can be updated.
viii THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
There are several chapters devoted to Exchange Traded Funds, so
links to various ETF families are included, along with information
on the S&P and Dow Jones industry group classifications. Links
to industry group com- ponents have been provided.
Unfortunately, the book is limited to a black-and-white format,
which does not do justice to many of the charts. For this reason a
wide-ranging library of multicolored charts has been included in
PDF format on the CD. Many of these charts are not included in the
book. All in all the CD will pro- vide you with some really helpful
background information to assist in the execution of the strategies
described in the book.
Strategic versus Tactical Asset Allocation
A successful investment strategy should be aimed at maximizing
return but not at the expense of undue risk. One way of achieving
this is to allocate assets among several investment categories. The
degree of “undue” risk depends on an individual’s psychological
makeup, financial position, and stage in life. If you are young,
you can assume greater risks than someone who is retired, sim- ply
because you are in a position to recover from a sharp loss. Time is
on your side. On the other hand, if you are close to retirement,
you do not have the luxury of time. Alternatively, a highly paid
executive will be less dependent on current portfolio income than
will a disabled person on workmen’s compen- sation. The executive’s
position therefore allows him to take a more aggressive investment
stance, and so forth.
The asset allocation process initially involves two steps. First
it’s necessary to make a general review of the three aspects
discussed in the preceding para- graph: personal temperament,
financial position, and stage of life. From here you can establish
a broad goal. Is it current income or capital appreciation, or a
balance of the two? If you decide on capital appreciation, it is
important that you have the personality to ride out major declines
in the market. On the other hand, would you be better off assuming
less risk in order to sleep more peacefully? There is only one
person who can make such decisions, and that is you. So look into
your financial position, psychological makeup, and stage in life
and decide for yourself. This process of formulating an investment
objective is known as strategic asset allocation. It is a process
that sets out the broad tone of your investment policy, and one
that should be reviewed peri- odically as your status in life
changes. We offer some guidelines on these aspects in the final
chapter of this book.
Tactical asset allocation is the process in which the proportion of
each asset category held in the portfolio is altered in response to
changes in the business climate. Thus, an older person may be
principally concerned with income and safety while a younger one
with risk-taking and capital appreciation. When
Introduction ix
the stage in the cycle that favors the stock market is reached,
both parties would increase their exposure. The difference would be
that conservative investors would take on a smaller position, say
from 10%-30% of the portfolio, Compare this to risk takers, who
might increase their exposure from 50% to 80%. In effect the level
of equity allocation is increased by both parties through the
tactical asset allocation process, but the strategic allocation
deter- mines that the more conservative people increase their very
low exposure to low, whereas younger people fluctuate between high
and very high.
Once again we can come back to a seasonal analogy. For example,
people in Florida and New England make strategic decisions about
what clothes to own. New Englanders will have a good supply of
heavy coats, thick sweaters, and ski jackets, whereas Floridians
will have only thin jackets and the occa- sional thin sweater.
However, in the winter months both will switch to winter clothes.
This is the tactical choice. New Englanders will wear their heavy
overcoats, etc., whereas Floridians will move from short-sleeved
shirts and short pants to long-sleeved shirts and long pants, and
perhaps a thin sailing jacket. Both are allocating their clothing
assets for winter wear because that is the prevailing season.
However, the New Englander wears much heavier clothes because the
climate requires such a strategic approach.
Why Do We Need to Allocate Assets?
There are three reasons why it makes sense to allocate assets.
First, it is a well- known investment principle that risk is
reduced when a portfolio is diversified into several different
entities. It comes down to the simple idea that if you own one
stock and the company goes bankrupt, you have lost your entire
portfolio. On the other hand, if you own eight stocks and one goes
bankrupt, the port- folio is hurt, but not mortally. The second
justification for allocation is to take advantage of times when an
asset is attractive and to avoid that same asset class when it is
not. Finally, the key to successful investing is as much about
dealing with yourself and remaining objective as it is about
attaining knowledge. Grad- ually and carefully shifting emphasis
from one asset to another will really help to reduce the emotional
aspect of decision making. Our seasonal approach and the framework
it provides will give you the confidence of understanding where you
are in the cycle and what conditions should be expected. The rota-
tion and balancing of assets should become a much more
understandable process from which it is possible to gain a high
degree of confidence.
The Seasonal Approach to Asset Allocation
A significant part of this book is devoted to optimizing the
allocation of a portfolio’s assets based on the changing character
of each unfolding business
x THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
cycle. The application of this approach assumes two things. First,
and most importantly, that the business cycle will continue to
operate. The cycle has been a fact of life throughout recorded
economic history, not only in the United States but in every other
capitalist country. Typically it encompasses a time span of roughly
four years from trough to trough, and is a reflection of human
nature in action as businesspeople alternate between moods of vary-
ing pessimism during recessions to outright greed and irrationality
in boom times. Because human nature remains more or less constant,
there are few grounds for expecting that the business cycle will
ever be “repealed.” There is no doubt that the nature of each
successive cycle will continue to change as it has in the past, but
unless human nature experiences a radical alteration, the cycle is
likely to stay with us permanently.
The second assumption is that every cycle progresses through a set,
chrono- logical series of events, each of which greatly affects the
performance of spe- cific asset classes. Later on we will take a
look at these events and discover how they may be recognized. Like
the seasons of the calendar year, the business cycle provides an
optimum time for buying and another for liquidating spe- cific
asset classes, such as bonds, stocks, commodities, or even
individual stock market sectors. If you are familiar with the kind
of crops that are suitable for the local soil and climate and know
when to plant and harvest, barring an unforeseen natural disaster,
it should be possible to obtain reasonable yields. In this
connection successful investing is no different than successful
farming. If you have an understanding of the characteristics of the
various asset classes and can identify the points in the business
cycle when they traditionally do well, it is possible to attain
superior returns relative to the risk undertaken. Because they vary
more in length and intensity, the business cycle “seasons” are not
as predictable as those in the calendar year. We also have to
recognize that occasionally our approach does not work.
Unfortunately that is a fact of life. However, the guidelines we
are offering will provide enough information to identify the
various business cycle seasons together with the type of perfor-
mance to be expected from each asset class during specific stages
of the cycle. We will discover the time to emphasize stocks over
bonds and which sectors to focus on. Winters are a time for less or
even no activity for most farmers. This is because the risk of
growing most crops is high. There is also a season in the business
cycle when risk taking in any asset should be kept to an absolute
min- imum. This means loading up with cash and waiting for the next
opportunity.
Successful Investing Is as Much about Psychology as Applying
Knowledge
It is a relatively easy task to read a book such as this and obtain
a theoretical understanding of why markets rise and fall. Beating
the market on paper is
Introduction xi
not that difficult. The trick is applying that knowledge on a
day-to-day basis and overcoming our own psychological deficiencies,
and it’s a difficult one to pull off. The reason is that as soon as
money is committed to an invest- ment, so is emotion. Before money
is committed, a declining price does not bother us, but once we
have money on the line and prices sell off, it is human nature to
be adversely affected by such a development. Just think of a little
thing like the sleep-at-night factor for instance. It makes little
sense to embark on a potentially highly profitable investment if
the slightest price setback causes you to sell at the wrong time.
It is paramount for each of us as individuals to assess the amount
of risk that we can deal with comfortably and the kind of rewards
commensurate with those risks. The investment objective and the
ability to take on risk will very much depend on our indi- vidual
financial position, emotional makeup, and stage in life. Nervous
Nel- lies should not expose themselves to a lot of risk, and
neither should retirees who obtain most of their income from
investments. By the same token, you might be one of those people
who has an aggressive, energetic nature and decide to
(uncharacteristically) invest in ultra high quality “dull” blue
chips during the early stages of a bull market. The chances are
that you will be bored with the performance of these investments
and decide to move into more aggressive stocks after prices in
general have moved substantially higher, exactly at the wrong time.
The key is to decide ahead of time your level for risk tolerance
and tendency, if any, to jump in at a moment’s notice. If you can
establish personal psychological traits such as this and act
accordingly, your success rate will undoubtedly be greater. For
example, establishing a realistic assessment of your risk tolerance
at the out- set would remind you of the dangers of making a sudden
and risky switch later on. One way around this is to design your
portfolio to be a little more aggressive at the outset. To some
extent this will satisfy your desire for the fast track.
The level of emotion is enhanced if we are constantly checking the
latest prices. This type of practice ensures that we will react in
a knee-jerk fashion to every twist and turn that the market throws
at us. This means that we will move down from the high level of
objectivity to one of subjectivity and loss of perspective as time
horizons shrink. Of course we cannot look away entirely, as a
regular judicious monitoring of the situation is a necessary part
of the process. However, if we get too close to the market, the
tendency is to respond to events and price changes instead of
following a carefully laid plan that responds to changes in
longer-term, more meaningful conditions. If you find you are always
changing your mind, the chances are that you do not have a sense of
perspective. The key is to set realistic goals and slowly work
toward them. Make gradual and systematic changes in your portfolio
based on changes in the indicators you are following. The best way
to lose perspective is to make large and frequent changes.
xii THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
The approach described here should help in this direction. First,
the very adoption of asset allocation principles and the seasonal
approach implies the establishment of reasonable investment goals
and the employment of a plan. If you make a plan and stick to it,
you are far less likely to be side- tracked by the latest news and
investment fashion. At Pring Turner Capital we are very
enthusiastic about expanding our management base, but not at the
expense of clients who do not sympathize with our approach. By
believ- ing in our methodology, they are in a better position to
understand our thinking and remain with us for the long term. The
situation for individual investors should be the same. By having
and understanding a methodology such as the one described here, you
will not only have greater confidence in going forward, but you
will be in a far stronger position to objectively and
systematically allocate your assets profitably. One of the key
ingredients of a successful salesperson is a complete understanding
and confidence in the product being sold. One of the key
ingredients of a successful investor is a complete understanding
and belief in the methodology being used. With- out that confidence
you will be easily put off track when things inevitably do not work
out as expected.
If you comprehend the process you will also get to learn what is
impor- tant for the long term and what is not. For example, in
recent years the monthly employment payroll numbers have become
notorious as market movers. However, payroll numbers are a
coincident indicator of the econ- omy. They are an indication of
where the economy is, not of where it is going. While surprises in
this economic series undeniably move markets for a day or so, they
rarely become beacons of fundamental changes in the economy.
Perverse reactions to these numbers often provide buying or sell-
ing opportunities for those following the slow ebb and flow of the
economy.
The process of asset allocation, on the other hand, involves a slow
but steady rotation of asset classes as evidence of changing
conditions gradually emerges. This measured shift means that the
emotional ups and downs will also be less intense because the
stakes of any specific change will be limited.
Some individuals have been highly successful trading markets over
the very short term. To do so they must focus 100% during the
trading session. Most of us do not have the time to apply such
intensity of effort. Fortunately, history shows that the majority
of successful investors have been those who have con- centrated on
the long term, by which I mean six months or more. We all know that
the media have a tendency to glorify the money managers or mutual
funds that have outperformed the pack over the latest quarter or
so. In real- ity, near-term variations in performance are heavily
influenced by chance or by the temporary success of the investment
philosophy or style favored by such managers. Those specializing in
smaller companies are bound to have their performance lifted when
these stocks come into fashion. The great temptation we all have is
to compare our own performance with the latest
Introduction xiii
investment stars. Such an exercise is doomed to futility. With very
few excep- tions, studies continually show that, over the long
haul, most money man- agers underperform the market. Equally as
important, those that beat the market in one period have a less
than even chance of doing it in the next, purely and simply because
investment styles and fashions change.
A common problem for many investors is not getting into a position
but getting out. The purchase decision is often based on sound
logic, but investors rarely ask themselves the question under what
conditions they should liquidate it if their expectations are not
realized. Establishing benchmarks for these situations is a
mandatory requirement for risk con- trol. Benchmarks convert the
investment from an open-end risk into a manageable known one. It
doesn’t matter whether such yardsticks are based on market prices,
economic indicators, valuation measures, etc. The important point
is that they should represent logical, soundly based crite- ria
that not only help to define the risk in question, but also enable
you to sleep more easily at night in the full knowledge that the
risk is limited.
If you think that rapid and dramatic shifting of assets is a
necessity for beating the market, you need to think again. In
reality, success in any ven- ture is achieved at the margin. This
is especially true for market success where the tortoise approach
implied by a gradual and continuous reallocation of assets will, in
the long-term, beat the investment hare.
xiv THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
1 Some Basic Principles of
Money Management
Introduction Diversification
Psychological Barriers to Diversification The Investor’s Two
Biggest Enemies: Inflation and Volatility and How Diversification
Can Help Using Diversification to Reduce the Risk from Owning
Individual Companies Using Diversification to Reduce Risk from
Market Fluctuations Diversification Can Result in Bigger Gains as
Well as Smaller Losses! ETFs and Diversification
The Power of Compounding Compounding and Interest Compounding and
Dividends
Introduction
A couple of decades ago I was driving from the airport with a
client and his Swiss banker. We were going over the incredible
performance that we had achieved in a matter of less than six
months. He remarked that in order to achieve such a performance I
had to have taken a tremendous amount of risk. That statement has
stayed with me ever since because it is not some- thing I had
thought about at that time, and yet cutting losses and managing
risk is the first rule of investing. I had been focusing on the
reward side of the equation, alsost totally unaware of the risk. I
had made money for my client, not because of any exceptional skill
but because I had been extremely lucky. Leverage works both ways
and I had enjoyed the positive aspects. I was soon to learn the
negatives, but that’s another story. However,
1
it does underscore the point that when committing money to the
markets, most people focus on how much they are likely to make.
Professionals, on the other hand, first ask how much risk they need
to undertake in order to achieve those gains. If the risk is
determined to be too great, the investment is not made.
This means that once you have established that the conditions for a
spe- cific investment are positive, the final step before
committing money is to set up an exit strategy. If you are
sympathetic to the technical approach of mar- ket analysis, this
would involve searching for a chart point below which a change in
trend would be signaled. A stop loss would be set accordingly. If
you are not technically oriented, you do not have the luxury of
setting a spe- cific price level. You will need to tackle the
problem another way by estab- lishing the reasons why you are
investing in that particular entity and then deciding what would
have to happen for those conditions to no longer be in force. If
and when that happens you would have mentally rehearsed your exit
strategy. In practical terms we have to take this risk management
strategy one step higher by managing the risk of the overall
portfolio.
There are a number of ways in which risk may be managed. The most
obvious is to diversify into several asset classes so that the risk
can be spread. A second method is to control the volatility of your
portfolio. Stocks with a high gain potential often come with a
commensurate degree of risk, mea- sured as volatility. Reducing the
number of such securities clearly reduces risk. Third, invest in
assets only when the condition for that particular class is
favorable. You wouldn’t think of planting seeds in the middle of
winter when the snow is on the ground. Similarly, do not buy assets
when the envi- ronment for them is unfavorable. The first two
points will be dealt with in this chapter and the third throughout
the rest of the book. First, though, let’s begin with the principle
of diversification.
Diversification
There is a well-known saying that you should not put all your eggs
in one basket. That principle applies very much to the investing
process. This is because investing in more than one asset or asset
class simultaneously helps to cushion your portfolio in case one of
your holdings does not turn out to be as profitable as originally
anticipated.
Diversifying means more than buying different stocks. It also
involves cash, bonds, inflation hedge assets, and so forth. We
could also include real estate, oil leases annuities, and many
other types of assets in the mix, but these fall outside the scope
of this book. Here we are concerned solely with bonds, stocks,
cash, and commodity-related assets because these are all liq- uid,
freely traded, and marked to market on a regular basis.
2 THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
One way of allocating assets is to use what we might call a
“static” approach. Under this scenario we would hold a little of
everything and never sell. Such a portfolio would limit losses from
such events as the 2000- 2003 bear market in stocks or the 1987
crash, when the stock market declined by 25% literally overnight.
By the same token it would have par- ticipated in the great bond
bull market that began in 1981, in the 1970-80 bull market in gold,
etc. However, such an approach suffers from two draw- backs, not to
mention putting brokers and financial planners out of busi- ness!
First, if one particular asset class does particularly well, it
would increase its proportion of the portfolio well in excess of
the original inten- tion. Worse still this overweighting would take
place at exactly the wrong time–i.e., when that particular asset
was peaking. Our objective here is to increase the proportion of an
asset when it is in the area of a major bottom, not a major peak.
Eventually, the portfolio would have to be rebalanced or this
static approach would lead to such inequalities that it would lose
most, if not all, of its diversification qualities.
Equally as bad, the static approach fails to capitalize on emerging
oppor- tunities and offers little protection from downside risk. No
approach is per- fect. However, does it not make sense to make hay
while the sun shines? In other words, when the economic, technical,
psychological, and monetary environment turns positive, it makes
sense to alter the asset balance in order to take advantage of such
opportunities.
A key objective in the money management process is to improve the
risk/reward ratio as much as possible. It’s not possible to avoid
risk alto- gether, but if you can limit risk but not give up too
much on the reward side, you are well on the way to success. Major
buying opportunities arise when the news is blackest and market
participants have responded by liquidating their stocks. One way of
measuring these swings in sentiment is to plot a two-year change in
prices. When the indicator is very low it indicates that sentiment
is extremely negative and virtually no one wants to own equities.
Chart 1-1 shows a history of this indicator back to 1900. When the
ROC falls below –25% and then rallies above that level, this is
usually a low-risk time for entering the market. Examples are
flagged by the upward pointing arrows. Even though this technique
has worked well in the 100 years cov- ered by the chart, no
investment approach is perfect. Just refer to the dashed arrow that
gave a false buy signal in the late 1930s. Similarly, when prices
have been rallying for a long time, investors become more confident
and careless in their approach. That’s when the risk is greatest.
The chart clearly shows that on those few occasions when the
indicator has risen above the 50% level and then fallen below it,
the risk has been high and the reward negative.
These examples have been flagged by the downward pointing arrows.
The dashed arrows reveal those periods when weakness was
incorrectly forecast.
Some Basic Principles of Money Management 3
This same data is reflected in Figure 1-1, where the annualized
rate of return over the ensuing 24 months from these signals is
represented on the y axis and the risk on the x axis. The place to
be is high on the return and low on the risk. In effect, as close
to the top left as possible, in the Northwest Quadrant as it is
known in the investment business. The place to avoid is the
Southeast Quadrant, where the risk is high and the reward low or
negative. Obviously in the real world it is not possible to get to
the extreme of the Northwest Quadrant, because there is always a
trade-off. Fortunately there are some techniques at our disposal
that help us to gravitate in this direc- tion. This can be done
through diversification and overweighting specific assets at the
appropriate time in the business cycle. A final approach is to buy
when an asset is historically cheap and sell when it is
historically expen- sive. This does not mean buying at the bottom
and selling at the top because what is cheap can become cheaper
and, as we discovered in the late 1990’s tech bubble, what is
expensive can become superexpensive.
A good example of the benefits of diversification can be seen by
com- paring Chart 1-2 to 1-3. Chart 1-2 shows the daily price
action of Merck in 2004 and 2005. The downside gap at the end of
September reflects some bad news when the company withdrew an
important drug from the market. It could easily have been good
news. The point being that investing in an
4 THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
Chart 1-1 S&P Composite and a 24-Month Rate of Change (Source:
pring.com)
individual stock can be more risky than you may have bargained for
because you are always at the mercy of the market’s reaction to
unexpect- edly bad news.
Chart 1-3 also shows some downside action at the end of September
2004, but this time it features the Holders Pharmaceutical ETF, a
diversified portfolio of drug stocks that includes MRK. In this
case the price drop was less dramatic. Whereas MRK had fallen from
$44 to $33, the ETF was only down from $74 to $72, a difference
between a 25% and a 2.7% loss. Quite often the spillover effect
from one stock in an industry will be greater than this, but it is
still substantially less risky than exposure to one stock. Note
also that while the performance of neither series was very
impressive in the ensuing period, that of the ETF was at least
slightly positive.
Diversification can be justified on two grounds, partly on the
factor of chance and partly to protect us from the possibility that
our assessment of the situation turns out to be incorrect.
Obviously when we purchase, say 12 dif- ferent stocks the odds of
the risk of a setback increases twelvefold. However,
Some Basic Principles of Money Management 5
Figure 1-1 Risk versus Reward for the S&P Yield 1948-1991
(Source: pring.com)
6 THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
Chart 1-2 Merck (Source: pring.com)
Chart 1-3 HOLDRS Pharmaceutical ETF (PPH) (Source: pring.com)
the odds of the whole portfolio being wiped out are extremely low,
substan- tially lower than if we were exposed to just one stock. By
the same token we may think of diversification as the spreading of
risk and limiting bad luck, but it also increases the chance that
one of our stocks may be a big winner. One could be the beneficiary
of a takeover, an oil find, a technological break- through, and so
forth.
A hidden advantage of diversification is that it allows us to make
gradual changes in our portfolios. Market conditions do not change
overnight but move in a slow and deliberate fashion.
Diversification permits us to rebal- ance the portfolio as more
evidence of a change in economic, financial, or monetary conditions
evolve. For example, we will learn later that market tops
experience a gradual change of industry leadership as early cycle
lead- ers peak out and late cycle leaders improve in relative
action. If we were just exposed, say to a bank stock, an early
leader, and felt that energy, a laggard, was about to emerge it
would be a difficult call. However, if we are diversi- fied into
several groups it would be easier to gradually phase out of the
early leaders as more evidence emerged.
Diversification needs to be a dynamic, not a static process. For
example, we could be diversified in cash, bonds, and stocks, split
into equal amounts. However, if the next 10-20 years is one of
strong price inflation, such a port- folio could easily lose
purchasing power. This is because the stock portion, which has
traditionally beaten inflation over long periods, would not be suf-
ficient to offset the decline in the income-producing assets, which
are harmed by rising prices.
Psychological Barriers to Diversification
There are several reasons why diversification is not widely
practiced, and they basically come down to one––laziness. In the
most simple of terms it is much easier to buy a stock or asset that
is presented to us in glowing terms by a media story, brokerage
report, or a friendly “insider,” than to under- take some difficult
and tedious research on a number of different stories from which we
will make our final picks.
Alternatively, many are tempted to buy a particular asset theme.
Perhaps the Administration is talking down the dollar. In
anticipation there could be a rush to purchase companies that
derive a substantial part of their prof- its from foreign currency
sources. This may or may not be a perfectly legit- imate investment
idea, but it is not a sufficient one to allocate all of our stock
portfolio to exporters. Conceivably the news or its expectation may
already be factored into the price. Perhaps our assumption is wrong
because these foreign economies are just entering a slump and are
not in a position to absorb our exports. In either situation this
one-idea overly sim- plistic allocation strategy leaves no room for
error.
Some Basic Principles of Money Management 7
A common mistake made by everyone is to extrapolate the recent past
into the future. It’s easy to fall into this complacent mode
because we are surrounded by commentators and media stories that
are sympathetic to current trends. It’s not only easier to go along
with the crowd, but the emerging economic statistics support such a
view: nonfarm payrolls, indus- trial production, and so forth.
Because the markets look ahead, this type of data has already been
discounted. It might flinch for a day or two when unexpected
numbers are published, but unless a particular number is the one
that starts to signal a change in the economic environment, the
market dye has most probably already been cast. The reason is that
markets look ahead and are concerned with indicators that lead the
economy, such as the Index of Leading Economic Indicators, money
supply, housing starts, etc. By observing these leading economic
series, it is possible to look ahead and anticipate possible
changes down the road. For example, monetary policy leads the
economy, and we may have noted that inflationary conditions are
intensifying due to easy money policies adopted several months
earlier. On the basis of this we may be tempted to buy precious
metal shares. This deci- sion may be perfectly sound, but only for
a limited time because the econ- omy, as we shall learn later, has
its own self-correcting mechanisms. It goes something like this.
The Fed injects liquidity into the system that eventually gets the
economy going again. As the central bank realizes that commodity
prices have started to rise and easy credit is no longer required,
the price of credit, interest rates, start to rally. Eventually
rising interest rates kill the commodity bull market because they
curtail consumer spending and busi- ness investment. The economy
then falls back into recession, interest rates decline, and the Fed
adopts an easy money policy. Thus for every action there is a
reaction. In effect we can say that every inflation eventually
breeds its own deflation.
In this example the rise in prices causes interest rates to rise as
well. Even- tually the higher rates make it unprofitable for
businesses to invest and pro- hibitively expensive for consumers to
borrow and the economy heads south. When this happens, inflation
hedge assets suffer and deflation hedge assets come into their own.
The investment in precious metal shares may do well for the time
being, but by putting all your eggs in the inflationary basket, the
final result will eventually turn out to be disappointing unless
you are able to spot the change in the investment environment and
take action accordingly.
Intellectual laziness can also be a barrier to diversification when
an investor chooses to concentrate on one security or asset class
in the hope of making a financial home run. Inevitably this quick
reach for riches will fail. The demoralization caused by this
failure will unbalance the emotional state of our investor. Under
such circumstances it will be almost impossible to make any
rational decisions. Performance is certain to suffer and valu- able
emerging new opportunities will be passed over.
8 THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
Diversification involves a certain degree of patience, thought, and
disci- pline. Unfortunately, beginning in the 1970s, the time
horizon of most investors started to shrink. More recently the tech
boom has placed the (perceived) virtue of instant analysis, quotes,
and greater leverage at the fingertips of everyone, leaving us all
to believe that fast and painless finan- cial rewards are just
around the corner. With such temptations in front of us, an even
larger barrier to the principle of diversification has been thrown
up.
In conclusion, profitable investing is best made in an environment
of objectivity. Quick home runs and off-the-cuff analysis, where
the focus is on profits, are not the way to achieve this. A far
better approach is through a program of diversification, where
assets are rotated slowly, incrementally, and thoughtfully. No
single asset can make or break the portfolio, nor, by the same
token, can it emotionally unbalance the investor.
The Investor’s Two Biggest Enemies: Inflation and Volatility and
How Diversification Can Help
A history of the markets indicates that over the long haul the
returns on stocks have been superior to both bonds and cash.
However, it is possible to lose a considerable amount of money if
stocks are bought and sold at an inopportune time because of their
volatility. Bonds too can be volatile but, barring a bankruptcy,
they always come back to their full face amount on maturity. Even
where they sell at a premium the holder is assured of a rate of
return throughout the life of the instrument.
In all cases, though, the longer the holding period, the lesser the
volatility. Inflation can also adversely affect the purchasing
value of a portfolio. It
is perhaps a more dangerous risk because it develops slowly over a
long period of time, and unless the rate of inflation is
particularly robust, it is almost invisible. In a sense, the
inflation risk is inverse to that of volatility because the former
becomes greater over time, whereas the passage of time reduces the
effects of volatility.
Diversification can help reduce both problems. On the one hand, if
a portfolio always includes some stocks and some bonds, the
inclusion of bonds will cushion some of the effects of a volatile
stock market. At the same time a portfolio that rotates part of
itself over the course of the busi- ness cycle will be able to
emphasize inflation hedge assets at the time of the cycle when
inflation is emerging as a threat. This part of the portfolio could
also include exposure to a mutual fund that seeks to replicate a
com- modity index. Alternatively, when deflation is the greater
problem, defla- tion-sensitive assets such as bonds and utilities
may be overweighted. Under such circumstances diversification
becomes both a static and dynamic process.
Some Basic Principles of Money Management 9
Using Diversification to Reduce the Risk from Owning Individual
Companies
The risk associated with individual companies independent of market
fluc- tuations is known technically as unsystematic risk. It is
generally accepted that risk declines as more stocks are added to
the portfolio. Figure 1-2 demon- strates this principle, where the
risk is measured on the y axis and the num- ber of stocks on the x
axis.
See how the average risk for the portfolio falls sharply with the
addition of six stocks and then begins to flatten out. By the time
seven or eight stocks are added there is very little to gain from
risk reduction. Thus, from the point of view of the individual, it
does not make much sense, from a risk management point of view, to
increase the portfolio to more than nine stocks.
Using Diversification to Reduce Risk from Market Fluctuations
Diversifying into a number of different stocks does not necessarily
protect you from a general market decline. This type of risk is
called systematic risk.
In this instance we are assuming that these stocks are in different
indus- tries and sectors. For example, if the portfolio consists of
nine issues, all of which are energy related, it will be very
vulnerable, for example, if a sharp drop in oil prices takes place.
This is because each of the components will
10 THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
Figure 1-2 Risk versus Diversification (Source: pring.com)
be energy price sensitive to one degree or another. Such a
portfolio would not fit the curve featured in Figure 1-1. In this
instance the curve would prob- ably experience a shallower descent
and would certainly flatten out at a higher (i.e., more risky)
level.
On the other hand, if these nine stocks were representative of nine
widely differing industries or sectors, the effect of
diversification would be far more beneficial. This is because
specific adverse industry developments would be cushioned by the
other stocks in the portfolio. However, because these industries
would represent a reflection of the overall market, they would not
offer much in the way of protection from a general market
decline.
This problem can be addressed by including other asset classes. The
degree of systematic (market) risk can therefore be controlled by
changing the balance of the assets it contains. This is only
possible because bonds, stocks, and commodities are often moving in
different directions. Cash, our fourth asset, is always static, of
course. The concept of similar and dissimilar price movements
simultaneously taking place is known as correlation. In our example
discussed earlier, the nine energy stocks would be closely corre-
lated. Let’s call this portfolio A. On the other hand, the nine
securities in the widely diversified stock portfolio would not.
Let’s call this one portfolio B. Taken together, though, portfolio
B would closely correlate with overall market movements.
A well-diversified portfolio should therefore be balanced to
include assets that are not closely correlated. Thus if one asset,
say stocks, is per- forming poorly, the diversification implied in
portfolio B will not be of much help. However, if this is combined
with an asset that does not closely correlate with stocks, say
precious metals or cash, the portfolio will be to some degree
cushioned.
Table 1-1 shows several asset classes and how they correlate. A
perfect correlation is indicated by 1.0. Thus aggressive growth
correlates perfectly with aggressive growth, as does money market
with money market. The lower the number, the weaker the
correlation. In this case the weakest cor- relation is between
growth and money market at -.0.09.
Diversification really comes into its own when the correlation
between asset classes and industry groups is greatest. If the
correlations are high, this means that the performance will be very
similar, so not much will be gained from diversification. This is a
major reason why an investor is advised to maintain some portion of
the portfolio in each principal asset class. In this way the
overall performance is hedged in the event that an incorrect market
call is made in any asset class.
Returning to Table 1-1, it is possible to use the data by way of an
exam- ple. Let’s say for instance that a retiree requires
substantial income. His stage in life immediately places him in the
conservative camp. He obvi- ously requires an income-producing
asset. Corporate bonds represent an
Some Basic Principles of Money Management 11
acceptable vehicle. Putting all of the assets into corporate bonds
would give him lots of income but no protection against rising
rates. Precious metals correlate poorly at 0.07 and would offer
some sensible diversifica- tion because they move in the same
direction as corporate bonds less than 10% of the time. While they
provide a hedge against inflation, their income stream leaves a lot
to be desired. Cash (0.04) and growth and income (0.51) would also
represent good diversification because each has an income
component, important to our investor, and neither correlates
closely with corporate bonds.
Correlation can also be extended to the equity market. Most people
refer to it as the “stock market.” However, it is more like a
market of stocks, where companies in different sectors are
simultaneously going their dif- ferent ways within given time
frames. Obviously there are bull markets, where most issues are
rising most of the time, and bear markets, where the opposite
conditions hold. However, there remains a dichotomy of perfor-
mance among the individual industry groups and their component
stocks. Consequently, it makes sense to construct a portfolio among
industry groups with a low correlation. For example, utilities tend
to outperform the averages during the late stages of the bear
market and the early phase of a bull market, when the economy is
typically in a recession. On the other hand, energy stocks put in
their best relative performance when the economy is close to
capacity and pricing pressures are greatest. That is also a time of
rising interest rates, which adversely affect the
high-dividend-pay- ing and capital-intensive utilities. Just look
at the diverging paths of the two momentum indicators reflecting
disparate industry groups in Chart 11-14 (in Chapter 11).
12 THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
Table 1-1 Correlations of Various Asset Classes
Aggressive Corporate Growth Growth and Precious Money Growth Bond
Income Metals Market
Aggressive 1 0.4 0.99 0.95 0.42 –0.07 Growth
Corporate 0.4 1 0.43 0.51 0.07 –0.4 Bond
Growth 0.99 0.43 1 0.98 0.42 –0.09 Growth and 0.95 0.51 0.98 1 0.39
–0.08
Income Precious 0.42 0.07 0.42 0.39 1 –0.08 Metals Money –0.07 0.04
–0.09 –0.08 –0.08 1 Market
Diversification Can Result in Bigger Gains as Well as Smaller
Losses!
Diversification, when correctly applied, reduces risk, but it does
not neces- sarily imply smaller rewards. In fact, it is possible to
enhance the perfor- mance. For example, if we are interested in
including a small cap growth stock, the volatility of the portfolio
is obviously increased. The result could be spectacular gains or it
could all end in tears. However, if we take this same allocation
and spread it among several stocks, we may still reap most of this
reward yet better manage our risk. For example, let’s say we buy 10
promising growth candidates. It’s probable that one or two of them
will turn out to be a dud, that most of them will be mediocre, and
that possibly one or two might experience substantial gains. At
first glance it may appear that this will result in a zero sum
game, but that is not the case. This arises because it is quite
real- istic to expect a good company to gain two to three or more
times in price over, say a three-year period. By the same token,
some of the losers may drop by 40-50%, but they are unlikely to go
bankrupt. If one does, the $10 stock that goes to zero is more than
outweighed by the $10 stock that moves to $30.
Table 1-2 shows that even with one issue losing $12 for a 100% loss
and two others experiencing sizeable losses, the overall portfolio
still experi- ences a nice 11% gain.
ETFs and Diversification
One way of obtaining diversification in one easy stroke is to
purchase securi- ties that already have a diversified portfolio.
Years ago this involved buying a
Some Basic Principles of Money Management 13
Table 1-2 Diversified Portfolio of Aggressive Stocks
Cost ($) Gain or Loss (%) Market Value
Company 1 12 100 24 Company 2 12 50 18 Company 3 12 –100 0 Company
4 12 –25 9 Company 5 12 –33 8 Company 6 12 50 18 Company 7 12 15
13.8 Company 8 12 15 13.8 Company 9 12 15 13.8 Company 10 12 15
13.8 Company 11 12 15 13.8 Company 12 12 15 13.8
Total 144 159.8 PROFIT $15.8 (11.0%)
broadly based mutual fund, either directly or indirectly from a
mutual fund company or as a mutual fund listed on an exchange. The
former are called open-ended funds because their size is literally
open ended. As new money pours in, so the fund grows in size,
provided, of course that new money is not dwarfed by redemptions.
Funds listed on the exchanges or over the counter are known as
closed-end funds because their portfolio size is set at the time of
listing. They are pools of professionally managed investment
capital that have a fixed number of shares that can only be
purchased from other sharehold- ers. The capitalization of these
funds, barring the raising of new capital through subsequent
offerings, is therefore closed. The principal difference between
the two is that closed-end funds can be purchased any time the
exchange is open, whereas open-ended funds can only be bought and
sold after the market has closed. When sales commissions are not
involved, as with no load open-ended funds, these securities always
sell at net asset value––i.e., the value of the fund based on
previous closing prices. Closed-end funds, on the other hand, sell
at a premium or discount to their net asset value, depending on
investor attitudes. If they are bearish the fund sells at a dis-
count to net asset value and if they are optimistic at a
premium.
Both types of funds offer special baskets of targeted securities,
such as type of capitalization, low cap/high cap, country,
Japan/Brazil, etc., differ- ing types of fixed income
(corporate/tax free) and so forth. They therefore offer some
measure of diversification.
The latest kids on the block are the Exchange Traded Funds (ETFs).
These are described at great length later in the book, but for our
purposes here they may be regarded as possessing the
characteristics of a closed-end fund that never trades at a
significant premium or discount to the targeted index. They also
have lower management fees. ETFs then are a great way to obtain
some quick diversification because they embrace a substantial
number of asset pos- sibilities such as cap plays, sectors,
industry groups, country indexes, and fixed income. We will have
much more to say about them in subsequent chapters.
The Power of Compounding
It is normal to think of investing as primarily returning capital
gains, but current income should by no means be overlooked because
the com- pounding factor of interest and dividends can be a
significant ingredient in the long-term performance of a portfolio.
We alluded earlier to the fact that time horizons have shortened
with the ability of technology to present us all with instant
analysis, quotes, and news. This is a shame because com- pounding
requires a large amount of time, together with the discipline and
patience to take advantage of this important investment principle,
and that is not within the grasp of most investors today.
14 THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
Compounding and Interest
Once you receive interest or dividends you are faced with a choice:
spend the money or reinvest it. If you are in a position to
reinvest your money, it will obviously grow faster, but probably
faster than you might think due to the interest-on-interest
effect.
We can see this from Table 1-3. In column four the cumulative total
increases only by the amount of the payment. This compares to
column seven, which reflects the reinvested proceeds as interest is
earned on inter- est. As with all compounding effects, the
difference is very small at the beginning but gradually increases
with the passage of time.
The timing of interest payments can also influences the
performance. The payments in Table 1-3 were made annually, but most
bond payment sched- ules are done on a semiannual basis. This
comparison is made in Table 1-4. The importance of the timing of
interest payments can also be appreciated from this example.
Suppose we assume that there are two $1,000 investments, one pays
monthly (such as ETF bond funds), and the other annually. The final
return, assuming a 10% coupon and a 20-year holding period, would
be $7,328 for the monthly payer compared to $6,727 for the annual
payment, a difference of almost 10%.
A third factor affecting compounding is the nominal interest rate,
which can have the biggest effect of all. To give you an example,
let’s assume that the original investment is $1,000. It pays on a
monthly basis and the holding
Some Basic Principles of Money Management 15
Table 1-3 Comparison between Yield on a Single Payout and
Reinvested Payout at 8%
Single Payout Reinvested Payout
Capital Annual Cumulative Annual Capital with Cumulative Value
Payout Total Payout Payout Total of
Payouts Reinvested Payouts
Year 1 $10,000 $800 $800 $800 $10,800 Year 2 $10,000 $800 $1,600
$866 $11,664 $1,664 Year 3 $10,000 $800 $2,400 $933 $12,597 $2,597
Year 4 $10,000 $800 $3,200 $1,008 $13,605 $3,605 Year 5 $10,000
$800 $4,000 $1,088 $14,693 $4,693 Year 6 $10,000 $800 $4,800 $1,175
$15,869 $5,868 Year 7 $10,000 $800 $5,600 $1,270 $17,139 $7,138
Year 8 $10,000 $800 $6,400 $1,371 $18,510 $8,509 Year 9 $10,000
$800 $7,200 $1,481 $19,990 $9,990 Year 10 $10,000 $800 $8,000
$1,599 $21,590 $11,589 Total $100,000 $8,000 $44,000 $11,591
$156,457 $55,653
period is 20 years. This would grow to $2,996 with a 51⁄2% interest
rate, $4,036 with a 7% rate and, as we saw in the previous example
$7,328 with a 10% rate.
Unfortunately, compounding in practice is not as simple as these
exam- ples would have us believe. This is because there is usually
a cost involved in reinvesting the proceeds. For example, bonds are
usually sold in round amounts of $1,000 face value. If you do not
have enough to purchase a round lot such as this you are out of
luck. Also, even if you do have the required amount it will still
be necessary to incur a transaction cost in order to purchase the
bond. We have not begun to mention state and federal income tax on
monies received in non-tax-exempt accounts that cannot be
reinvested, nor the inability to reinvest in the event that the
general level of interest rates falls during the lifetime of the
bond.
One way around some of these problems is to invest in ETF bond
funds, which permit the accumulation of odd dollar amounts, but
taxes and com- mission costs still apply.
16 THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
Table 1-4 Table of Annual Yield Equivalents
Semiannual versus Annual Yield Equivalents (Yield Based on Annual
Compounding Equivalent to Stated Semiannual Yield)*
Semiannual Annual Semiannual Annual Semiannual Annual Yield Yield
Yield Yield Yield Yield
3 3.02 7 7.12 11 11.3 3 1/4 3.28 7 1/4 7.38 11 1/2 11.57 3 1/2 3.53
7 1/2 7.64 11 1/2 11.83 3 3/4 3.79 7 3/4 7.9 11 3/4 12.1 4 4.04 8
8.16 12 12.36 4 1/4 4.4 8 1/4 8.42 12 1/4 12.63 4 1/2 4.55 8 1/2
8.68 12 1/2 12.89 4 3/4 4.82 8 3/4 8.94 12 3/4 13.16 5 5.06 9 9.2
13 13.42 5 1/4 5.32 9 1/4 9.46 13 1/4 13.69 5 1/2 5.58 9 1/2 9.73
13 1/2 13.96 5 3/4 5.83 9 3/4 9.99 13 3/4 14.22 6 6.09 10 10.25 14
14.49 6 1/4 6.35 10 1/4 10.51 14 1/4 14.76 6 1/2 6.61 10 1/2 10.78
14 1/2 15.03 6 3/4 6.86 10 3/4 11.04 14 3/4 15.29 7 7.12 11 11.3 15
15.56
* The nominal annual yield tabulated here assumes semiannual
compounding. If interest rates were com- pounded only once a year,
the nominal rate would be slightly higher. For example, an 8% yield
assuming semiannual compounding is equivalent to an 8.16% yield
assuming annual compounding.
The purest method is to purchase zero coupon bonds, the mechanics
of which are discussed in Chapter 10. With zeros the compounding
effect is built into the price, as is the assumption that the
prevailing rate of interest rate remains constant. The problem with
zeros that are not held to maturity is that they are extremely
price sensitive to changes in the level of interest rates, and that
works both ways.
Investing a lump sum and watching the investment compound is only
one alternative; many people set up plans that require regular
fixed contribu- tions. The compounding effect of such plans can be
truly remarkable. One of the most impressive compounding tables I
have ever seen is based on sta- tistics provided by Market Logic of
Fort Lauderdale Florida (Table 1-5). It shows that a few early
contributions can be far more effective than many later ones. The
table, which assumes a 10% reinvestment rate, presents us with two
investors. The first makes a total contribution of $14,000 and
the
Some Basic Principles of Money Management 17
Table 1-5 Regular Contributions and Compounding
Investor A Investor B
8 0 0 0 0 9 0 0 0 0
10 0 0 0 0 11 0 0 0 0 12 0 0 0 0 13 0 0 0 0 14 0 0 0 0 15 0 0 0 0
16 0 0 0 0 17 0 0 0 0 18 0 0 0 0 19 2,000 2,200 2,000 0 20 2,000
4,620 2,000 0 21 2,000 7,282 2,000 0 22 2,000 10,210 2,000 0 23
2,000 13,431 2,000 0 24 2,000 16,974 2,000 0 25 2,000 20,872 2,000
0 26 0 22,959 2,000 2,200 27 0 25,255 2,000 4,620 28 0 27,780 2,000
7,282 29 0 30,558 2,000 10,210 30 0 33,614 2,000 13,431
(Continued)
Table 1-5 Regular Contributions and Compounding (Continued)
Investor A Investor B
Age Contribution Year-End Value Contribution Year-End Value
31 0 36,976 2,000 16,974 32 0 40,673 2,000 20,872 33 0 44,741 2,000
25,159 34 0 49,215 2,000 29,875 35 0 54,136 2,000 35,062 36 0
59,550 2,000 40,769 37 0 65,505 2,000 47,045 38 0 72,055 2,000
53,950 39 0 79,261 2,000 61,545 40 0 87,187 2,000 69,899 41 0
95,909 2,000 79,089 42 0 105,496 2,000 89,198 43 0 116,045 2,000
100,318 44 0 127,650 2,000 112,550 45 0 140,415 2,000 126,005 46 0
154,456 2,000 140,805 47 0 169,902 2,000 157,086 48 0 186,892 2,000
174,995 49 0 205,518 2,000 194,694 50 0 226,140 2,000 216,364 51 0
248,754 2,000 240,200 52 0 273,629 2,000 266,420 53 0 300,002 2,000
295,262 54 0 331,091 2,000 326,988 55 0 364,200 2,000 361,887 56 0
400,620 2,000 400,276 57 0 440,682 2,000 442,503 58 0 484,750 2,000
488,593 59 0 533,225 2,000 540,049 60 0 586,548 2,000 596,254 61 0
645,203 2,000 658,079 62 0 709,723 2,000 726,087 63 0 780,695 2,000
800,896 64 0 858,765 2,000 883,185 65 0 944,641 2,000 973,704
Less Total Invested –14,000 –80,000 Equals Net Earnings 930,641
893,704 Money Grew 66-fold 11-fold
second a total of $80,000, yet they both end up about the same in
total dol- lars. The difference, is that investor A makes his
contributions between the ages of 19 and 25, whereas investor B
pays the same annual $2,000 but pays from age 26-65. Logic would
suggest that the second investor, who makes a substantially larger
contribution, would end up with a significantly larger portfolio
but that is not the case. He does end up with a slightly larger
total, but when the contributions are deducted investor A wins out
handsomely with a 66-fold increase compared to investor B, who only
achieves an 11-fold gain. This table was first calculated when the
general level of interest rates was much higher than at the time
when this book is being published, but the same principle, that the
early bird gets the worm would still apply, just that the returns
for both parties would be considerably less.
Compounding and Dividends
When we think of compounding it is usually interest earned on
principal and accumulated interest reinvested from prior periods
that come to mind. However, the compounding element of dividends
over long periods of time can also play an important role in the
total return. Dividend reinvestment is usually a dynamic process.
This is because it does not just include the compounding of
reinvested dividends, but dividends themselves increase over the
years. A growth company does not typically offer a very high divi-
dend yield, but if it is truly growing it will increase those
dividends on an annual basis. After a period of 10 years or so the
current dividend could offer a huge yield based on the original
investment. Let’s say you invest $100 in year one and the dividend
yield is 2% or $2. Let’s also say that the dividend is increased by
10% per annum.
Year 1 $2.00 Year 2 $2.20 Year 3 $2.42 Year 4 $2.66 Year 5 $2.93
Year 6 $3.22 Year 7 $3.54 Year 8 $3.90 Year 9 $4.29 Year 10
$4.71
Over a 10-year period the yield on the original $100 investment
becomes 4.71% and the total dividends received grow to a healthy
$31.87.
Some Basic Principles of Money Management 19
The total return, excluding capital gains, would not be
extraordinary, but would certainly represent a credible return. A
gradually rising dividend stream is, therefore, a valuable aid to
an investor concerned with keeping up with inflation.
We can take this a step further by comparing the initial yield with
various dividend growth rates. In Table 1-6 we compare the
compounding effect of a $10,000 investment in three equities with
differing yield and growth char- acteristics. For the purpose of
this example it is assumed that all three com- panies are growing
consistently and are not therefore cyclical in nature. We are also
working on the assumption that the stock with the highest yield
also has the slowest dividend growth rate and vice versa. This is
logical because a company that pays out more in the form of
dividends generally has less cash flow for expansion than more
miserly dividend payers.
In the example on the left, the company pays out an initial
dividend of $400 (i.e., 4% of $10,000) and the dividend is
increased at a rate of 5% per annum. The other two companies yield
less, 2.5% and 1% respectively, but
20 THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
Table 1-6 Compounding Effect of Dividend Payouts
Company A Company B Company C
Initial Yield 4% Initial Yield 2.5% Initial Yield 1.0%
Dividend Increases Dividend Increases Dividend Increases Year 5%
per Annum 10% per Annum 15% per Annum
1 400 250 100 2 420 275 115 3 441 303 132 4 463 333 152 5 486 366
175 6 511 403 201 7 536 443 231 8 563 487 266 9 591 536 306
10 621 589 352 11 652 648 405 12 684 713 465 13 718 785 535 14 754
853 615 15 792 949 708 16 832 1044 814 17 873 1149 936
grow faster. From a purely income point of view, the first company
compares very favorably in the first few years and only falls
behind in years 12 and 17, as the higher-growth companies come into
their own. In general higher- growing companies will also increase
more in value but they will also be much more volatile. This
compares to slower–growing, higher-yielding companies, which will
be associated with significantly reduced volatility. This
investment characteristic will appeal especially to more
conservative investors.
Some Basic Principles of Money Management 21
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2 The Business Cycle:
Nothing More than a Seasonal Calendar
Why the Business Cycle Repeats A Typical Cycle The Economic
Sequence Introducing the Concept of Rate of Change More on the
Chronological Sequence of Events Using Indicators to Demonstrate
the Sequence
Economic history in the United States goes back basically for 200
years. Dur- ing that time it is possible to observe a consistent
fluctuation in the level of
economic activity between growth and contraction. This experience
is not limited to the United States but also extends to other
countries. Indeed, in Europe the record keeping, though vague,
extends back further, but the same repetitive observation holds
true. The alternation of growth with contraction is known as the
business cycle and it lasts approximately 41-42 months from trough
to trough. The cycle is essentially a reflection of psychology, the
alter- nation between caution, optimism, greed, and fear, so there
is no reason why it will not continue to operate unless there is a
substantial change in human nature. In this chapter we are
concerned with the questions of defining the business cycle and
examining the way in which it works. Later on we will take a look
at its importance for the asset allocation process and how an
attempt at understanding the cycle can aid in obtaining superior
results.
At this point you may be left with the impression that the business
cycle operates on a regular beat and repeats more or less exactly.
Unfortunately
23
that is not the case because each cycle has its own
characteristics, including duration and magnitude. Remember, the
41-month time span cited earlier is an average, which means that
the period between cyclic troughs can fluc- tuate considerably.
There are many reasons why this is so, but I believe they can be
narrowed down to two principal ones.
The first is due to the fact that the business cycle, otherwise
known as the Kitchin cycle (after its discoverer, Joseph Kitchin)
is dominated by far stronger and longer economic cycles, all of
which are operating simultaneously. Two of the more dominant are
the Juglar, or 10-year cycle and the Kondratieff, or 50- 54 long
wave cycle. In his classic book Business Cycles, Joseph Schumpeter
iden- tified the three cycles, which he combined into one. Chart
2-1, which Topline Charts kindly allowed us to produce, shows this
cycle with key markets from the eighteenth century to around the
turn of the millennium. We shall have a lot more to say on the
Kondratieff cycle and secular or very long-term trends in Chapter
4. However, for now all we need to know is that the Kondratieff
Wave is essentially concerned with inflationary and deflationary
forces and that its associated secular trends dominate the
characteristics the individual business cycles that form part of
it. For example, each business cycle has an inflationary and a
deflationary part. If the prevailing secular trend is inflation-
ary, this will mean that the business or Kitchin cycle will
experience a longer and more pronounced inflationary phase as well.
In effect the bull market in commodities and bond yields associated
with the Kitchin cycle will be longer and have greater magnitude
when the long wave is experiencing an inflation- ary trend. The
most recent secular or very long-term inflationary trend began in
the mid-1930s and lasted through the 1970s. Between 1981 and 2005
the dominant force, as flagged by bond yields was deflationary
(i.e., the Kondrati- eff down wave), which has resulted in long
Kitchin-associated bull markets in bond prices and relatively short
bear markets.
The second principal reason why the characteristics of each
business cycle differ lies in the fact that the economy consists of
many parts or sectors. These sectors do not rise and fall with
equal proportion but differ from cycle to cycle. For instance,
there may be a structural reason why the economy needs more housing
than normal. Perhaps there has been a shift in demo- graphics where
a higher proportion of the populace is in a family formation phase.
This will mean that housing will play a more dominant role in the
recovery than normal. Usually when a sector experiences
above-average per- formance, businesspeople factor it into their
decision making process. As a result, temporary strength is often
confused with what may be thought to be the new norm, and
businesspeople in the housing sector become unduly optimistic. In
turn, this causes them to anticipate greater potential rewards and
so become willing to take on additional risk. The promise of easy
prof- its inevitably results in careless decisions and distortions
in the industry. In another cycle it could be an excess of consumer
debt and a financial imbal- ance in the banking system.
Alternatively, a sharper commodity price rise
24 THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
than normal could encourage businesses to accumulate inventory.
That’s fine while sales hold up, but when they decline these
“adequate” inventory levels are then perceived as excessive.
Whatever the reason, we usually find that one sector of the economy
overbuilds or overlends. In this way these sectors increase their
representation in terms of economic share on the way up and
exaggerate the speed of the decline on the way down.
We can also introduce a third reason that accounts for different
business cycle characteristics, and that lies with the fact that
the structure of the econ- omy changes with the passage of time.
For example, in the nineteenth century the U.S. economy was
strongly represented by farmers. Later, manufacturing dominated,
and in the latter part of the twentieth century, the service indus-
tries came to the fore. Throughout the whole period the role and
influence of federal, state, and local governments grew. In the
nineteenth century, the big economic number was pig iron. Who
follows that series in this, the day of the Internet? The net
result is that the economy is now less influenced by cyclic
elements than it once was, especially as the role of government and
its associ- ated transfer payments have added a layer of stability
to the whole thing. That
The Business Cycle: Nothing More than a Seasonal Calendar 25
Chart 2-1 Four Long Waves. (Courtesy Ian Gordon, The Long Wave
Analyst, www.thelongwaveanalyst.ca. Statistics prepared by Topline
Investment Graphics, www.topline-charts.com. Graph was prepared by
Lucidlab, www.lucidlab.com)
is not to say that longer-term imbalances cannot arise, but from
the point of view of individual business cycles, volatility appears
to be on the downswing.
It is also important to understand that most of the processes
involved with the business cycle are cumulative in nature so that
once they have gained upward or downward momentum, such trends tend
to perpetuate. It takes a long time to slow down and reverse the
course of an oil tanker or freight train, and so it is with the
economy. One key mistake made by many observers, including this
one, is to underestimate the resiliency of these trends. It is
amazing that once a recovery gets underway it becomes very
resilient to unexpected shocks, whether political, natural, or
human made.
Having made a few general observations about fluctuations in
business activity, it is now time to return to our main theme,
which is asset allocation around the business cycle
In this chapter we are principally concerned with the Kitchin, or
four- year cycle. Figure 2-1 shows an idealized cycle, where the
sine curve repre- sents the growth path of the economy. The
horizontal equilibrium line indicates a period of no growth. When
the sine curve is rising above the equilibrium line, it tells us
that the economy is growing at a faster pace. When it peaks out and
starts to decline the economy is still growing, but at a slower and
slower pace. Eventually the line slips below zero, or equilib-
rium, which means that the economy is shrinking. As long as it is
falling below zero, the downside economic momentum is picking up
steam. Even- tually the sine curve rises, but because it is below
zero, the economy is con- tracting. However, the pace of decline is
slowing. Finally, when it crosses zero, growth becomes positive and
a new recovery is underway.
We said earlier that the economy is not homogeneous, but consists
of a number of sectors, each of which goes through a series of
chronological sequences. How then can we talk about “the economy”
as if it is a single unit? The answer is that the theoretical
growth path in Figure 2-1 is representative of what we might call
the coincident part. For example, the economy also con- sists of
leading and lagging sectors, each simultaneously undergoing their
own, but separate, paths of growth and contraction. Our diagram
reflects those sectors that are sandwiched between them. If we were
to add up all of the sectors––some leading, some in the middle, and
some lagging and average them––the curve shown in the diagram would
offer a fairly close fit. When we refer to the economy in this and
subsequent chapters, we mean the aggregate sum of business activity
as reflected in the diagram.
Why the Business Cycle Repeats
The business cycle really consists of a number of economic
decisions made by people, either individually or as a group. The
alternation between recovery
26 THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
and recession is a direct function of people responding to positive
stimuli (the recovery) and then constantly repeating the same
mistakes that cause a recession or slowdown in the growth rate.
These decisions are psychologically driven, either in anticipation
of future conditions or as a response to existing ones. For
example, corporations expand their capacity to produce because they
anticipate future growth. On the other hand, workers are often
fired in response to declining sales, etc. The key point is that
the business cycle devel- ops because human nature is more or less
constant. They say that history repeats but never exactly. The same
is true of the business cycle. People make the same mistakes, but
each time it is different people in different sectors making
mistakes of differing degrees. For example, it’s human nature to
extrapolate the recent past. If your favorite sports team has been
on a win- ning streak, it’s normal to expect them to continue.
Similarly, if the economy has been expanding for a year or so, most
people will have gotten used to the positive conditions. Because
the news background will also be favorable, there are few grounds
for expecting economic weakness. If there were, peo- ple would take
action in anticipation.
In an opposite sense, if business activity has been contracting and
your company is really suffering along with others, it is easier to
make those cost- cutting decisions. On the other hand, if you are
certain that the economy is going to pick up next month, you would
perhaps postpone or cancel the
The Business Cycle: Nothing More than a Seasonal Calendar 27
Figure 2-1 Business Cycle Growth Path (Source: pring.com)
cost-cutting exercise. “The regularity is in the pattern of these
reactions, not in the cycle itself” is how the late Dr. Richard
Coghlan put it in his book Profiting from the Business Cycle
(McGraw Hill, London, 1992).
While the explanation here will provide you with a framework from
which to allocate your investments around the business cycle, it is
not and cannot be an actual map containing pinpoint accuracy. This
is because no business cycle pattern is repeated exactly. If it
were, the forecasting process would be easy and would most probably
be instantly discounted by the markets. Generally speaking, people
learn from their own experiences and will not repeat identical
errors in successive cycles. For example, you might be a property
developer who got caught in the previous downdraft with excess
housing inventory, which was eventually sold at a loss. This would
have been a painful mistake, and you would certainly take steps to
make quite sure to avoid or certainly mitigate such problems in the
future. However, not every- one who experiences one business cycle
will be around for the next, because there is a constant process of
renewal and replacement as new par- ticipants emerge and old hands
retire from the scene. Also, the degree of distortion for each
economic sector differs in each cycle, so even those who remain
constant in an industry could quite possibly emerge unscathed and
therefore relatively ignorant of firsthand experience of the
pitfalls of over- expansion. The longer the time span that develops
between these experi- ences, the greater the potential for
distortion. Thus the cloud from the damage of the 1929-32 bear
market that hung over market participants for decades after was
pretty well forgotten at the time of the peak in the tech bubble in
2000. Each generation has to gain from its own experience. Knowing
that someone else went through trials and tribulation may help a
bit, but there is nothing like firsthand experience of financial
suffering to give a person conservative financial religion.
At the beginning of the cycle, decisions are made cautiously with
great thought because the memory or the previous business
contraction is quite vivid. The most common mistakes develop at the
end of the recovery when things are at their best, overconfidence
abounds, and companies plan major expansions. Because everyone else
in that particular industry is experienc- ing the same buoyancy in
sales and profits, everyone is in an expansionary mode and that
creates a condition of excess capacity. This overbuilding is not
obvious at the time because sales are strong and profit margins
fat, but when revenue weakens, the excesses become obvious for all
to see. At that point workers are laid off and the economy
contracts. Such extremes are not confined to the manufacturing and
construction industries but can appear in any sector. It never
ceases to amaze me that the brokerage industry, which should know
better, is often seen moving into plush new offices right at the
peak of an equity bull market. The justification for the increased
overhead is typically based on the maintenance of an unsustainable
level of commissions
28 THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOC