Guest Author: Jeffrey Dow Jones is a registered investment advisor with Jones & Company which has managed a family of hedge funds for 27 years. Their flagship fund, High Sierra Partners, is currently the #1 ranked fund of funds with a track record greater than ten years in the HFN Multi-Factor Ranking Database. Jeffrey is also a partner at Draco Capital Management and publishes a free weekly investment newsletter, The Draconian. Read Part 1 and Part 2.
We’ve covered a lot of ground so far.
Pat yourself on the back if you’ve stuck with us. I know this is complicated stuff, but even a basic understanding of this debate will give you a leg up, if not in your actual investing then at the very least in your discussions friends and colleagues.
Here at The Draconian, we consider ourselves contrarians. And the most important part of being a contrarian is questioning everything that is blindly assumed to be correct. Occasionally the most commonly held views in the marketplace are correct, but a lot of the time they are not. When it comes to inflation, investment professionals, senators on Capitol Hill, and Joe Main Street all seem unified in their fear of it at present, and even further, have convinced themselves that’s a near certainty down the road.
As we’ve outlined above, we don’t think it’s quite such an open and shut case. In the event that it’s not, it could have serious implications for your investment portfolio. Investing against the wrong framework when it comes to inflation could lead to significant underperformance over the next decade. Assuming that higher and higher price levels lie ahead will damage your investments if that scenario fails to materialize, though disregarding the possibility of inflation altogether could have equally dire results.
Now we’ll help you navigate the narrow channel unfolding before us.
Bernanke the Acrobat
The Fed is walking an extremely tight rope right now. Job number one is obviously staving off current deflation. Today, that job seems just about accomplished. Uncle Sam (acting a lot more like Captain America with its heroic spending) has been bold and creative in the battle to beat it back. Prices have stabilized and there are loads of stimulus still to come.
The problem with fighting deflation is that you have to do inflationary things. And that’s the crux of the current tight rope act. At some point after you’ve got deflation licked you run the risk of letting inflation get out of hand.
I mentioned a few weeks ago that the economy, while in all likelihood technically recovering, is still pretty sick. Should inflation get out of hand, it’s arguably much too sick to tolerate the medicine needed to keep inflation at bay. The Fed wants to – needs to – avoid runaway inflation, and will allocate every resource and tool at its disposal to thread this needle.
Nobody wants to send the fragile economy back into recession, so raising rates any time remotely soon is simply not an option. And should that become necessary, it will be telegraphed to the market far in advance. This is all further complicated by the fact that households are still deleveraging and trying to service and pay down debt; higher interest payments could set that back dramatically. People have to save right now for a lot of reasons.
Low rates in the banking system mean generally low yields everywhere else and this becomes an important consideration for investing and portfolio construction. This brings us to the first facet of this strategy.
A New Psychology
Given the new normal of slower economic growth, higher unemployment, and generally reduced yields, investors need to make peace with a fundamentally lower expected rate of return given a baseline level of risk.
10% is the new 20% and 5% is the new 10%. It will still be possible, of course, to earn returns of 15-20% or more, but those returns will be a lot harder to find. Most will exist in the alternative investment space, where only high net-worth investors may participate, however fair or unfair that may be. Those that are more readily available (or aggressively marketed) will carry significantly larger risks. In life, “The Best” is often the hardest to find and this will remain true with investments.
Investors should always, always, always make investments in a risk-adjusted context. Hopefully everybody has learned their lesson on the risk side. During the last five years, in the middle of a major worldwide hunt for yield, investors did some stupid and risky things to earn a decent rate of return. Making 15%/year isn’t worth it if it carries a high probability of significant losses in any given period. The 5%/year return stream might be considerably more attractive if the odds of experiencing a significant loss are low or nil.
The side effect of this is that investors are going to need to make peace with fundamentally lower returns and it will require a new investing mindset, one that revolves around reasonable expectations. This isn’t to say that investors should avoid higher-risk investments altogether, but that they should never represent too large a portion of a prudent investor’s portfolio.
Keep in mind that there are fundamental, economic reasons to justify lowered return expectations. Assuming a new era of lower GDP growth (think 1-3% instead of the 5-7% we’ve been enjoying for a while), a few things will change permanently. No longer will unemployment average 5%; we will all need to accept average unemployment of around 8%. It means the permanent closure of many businesses, permanently reduced home construction, and – especially now that the finance bubble has burst – permanently reduced consumer spending. All of this will be a drag on asset values, and therefore investment returns.
Investors also must make peace with the fact that investing is an activity that will become substantially more work-intensive and skill-based. As we pointed out before, passive equity strategies are dead. They are not coming back to life any time soon, either. Don’t be fooled by selective windows; passive strategies appear to work over short periods, but over the long run, they are inferior to active management. This isn’t to imply that all active managers are better than the market as a whole – by definition, they cannot be – but rather that a good active manager should be generally preferred to the market. Finding the good ones takes (you guessed it) work.
A brief sidebar: last Thursday Bloomberg TV was reporting all day on a study of how active mutual fund managers as a whole have outperformed passive managers over various short and long term windows. This might be the first time in my career that I’ve heard a story like this widely reported in the media.
And as I’ve mentioned before and will continue to emphasize, the economy may indeed be recovering but the recovery will be dichotomous. Some sectors and companies will lead the way and others will lag significantly. With marginal aggregate economic growth over the next few years, it’s not going to feel like a recovery. There are substantial opportunities in the market right now and there will be plenty in the future, but it will require skill to identify them.
In the coming weeks we will outline several more of these opportunities, sectors and companies to pursue and avoid.
I’m not sure that the world is ready for an environment where U.S. inflation is flat or suffers from regular bouts of deflation.
In this kind of landscape, real estate should be avoided altogether as an investment. Keep in mind that before the real estate bubble, few thought of real estate as an attractive investment. Those that did, did it professionally and really had to work the property and the financing to make it pencil out. Buying a house for simple price appreciation, relying on a future buyer to pay more for it than you did, is simply not a viable strategy. Not in real estate. Buy your house to live in it. Don’t expect to make a lot of money on it. Fortunately this mindset is changing and that’s a healthy thing to repair the damaged psychology in real estate.
In a deflationary environment, stocks are a loser’s game. The classic examples of secular deflationary cycles are the great depression or post-1993 Japan, but any kind of deflation is disastrous for stocks as companies struggle with lower and lower prices, lower and lower profits, and eroded asset value. In this type of world, there is no reason whatsoever to allocate a large portion of your portfolio to equities.
If you can skillfully trade the shorter-term swings of the market, you will be rewarded. Unfortunately, this too is difficult for the average investor to do. Typically, one has had to look to the world of alternative assets i.e. hedge funds for this as traditional mutual funds tend to view equities as long-term investments. For whatever reason, the public seems comfortable with this concept and the tax code and regulatory structure has created legitimate incentives for long-term acquiring and holding as opposed to short-term buying and selling.
If the next decade is one where the stock market goes up and down and up and down and ultimately winds up about where it started (recall the 1970’s), expect to see traditional mutual funds look a lot more like alternative funds. This was a trend that grew out of the bear market of 2000-2003, before getting less popular when the market started going back up again. The last year has been one of asset stabilization and putting out fires, but now that this cycle has worked its way through, expect nearly all growth and innovation in the mutual fund industry to center around the development alternative strategies.
More funds will go short or allow a certain portion of their fund to go short. Other funds may emphasize shorter-term trading rather than long-term investing, buying and selling stocks with greater frequency than they historically have. This will, of course, be less tax-efficient and will mean higher expenses to the portfolio, but those costs may certainly be worth it.
Another popular strategy that grew out of the dot-com bubble-burst was allocating to index funds, passive growth funds, and low cost funds. For some ridiculous reason everybody developed the notion that funds with low fees were somehow better than funds with high fees and managers that charged high fees should be categorically avoided. This insane misunderstanding of value dissuaded a lot of investors from pursuing alternative mutual funds or hedge funds, an action which hurt them even more when everything imploded in 2008. Alternative funds, on the whole, dramatically outperformed traditional funds last year, both the handful that are traded as a mutual fund and the majority that are structured as a limited partnerships.
Regardless of what kind of inflation rate we see, in a general sense, active strategies will be preferred to passive strategies. In a deflationary environment, this preference will most likely be magnified.
Don’t forget about bonds. Bonds are great return streams when prices are deflating, but their principal value is at risk in deflationary scenarios. Bonds tend to get a little more risky in these situations because the entities behind the debt find themselves on shakier footing and become a higher risk for default. Investors should seek out high-rated corporate bond funds, or expose themselves to government and agency debt.
Lastly, in deflationary environments cash is a perfectly fine investment. When prices are dropping and dollars are becoming more valuable, why not keep more of them around? Yes, this is exactly the vicious cycle that policy makers fear. But should low or negative inflation become part of the “new normal,” investors will need to carry a significantly higher portion of cash in their overall portfolios than they have in the past. For whatever reason investors tend to get antsy when they aren’t 100% invested, but there’s nothing wrong with patiently holding cash for tactical opportunities or relative return in deflationary environments.
A blueprint for disinflation (or deflation)
For the record, our present view is that deflation will for the most part be kept in check and inflation will run cooler than many in the media and investment industry may lead you to believe. Investor sentiment and public opinion may indicate inflation or even hyperinflation, but at the individual level, nobody is acting as though they are truly concerned about inflation. Until that changes, our view will be that of “less inflation than most others are thinking.” That’s the kind of stance we like to have, one that is both contrarian and fundamentally correct.
I’ll boil it down to a simple, four-pronged strategy for investing in a deflationary/disinflationary environment:
- Avoid owning any fixed assets you don’t have to.
- Seek out alternative funds and choose them over traditional (buy-n-hold) equity funds. Trade stocks tactically rather than investing blindly and broadly. Look outside the U.S., too, at emerging economies that aren’t deflationary and at alternative strategies such as equity long/short and commodities trading.
- Overweight exposure to high-quality corporate bonds and government debt.
- Keep a lot of cash.
Current fears of excessive inflation are predicated on a view that the Fed will stand idly by or will be powerless to keep it from running away. I think that view is incorrect and for what it’s worth, the bond market agrees with me. (Or, more modestly and accurately, I agree with the bond market.)
The Fed does have the tools it needs to maintain price stability. The wildcard, of course, is politics. Will the Fed stay true to its mandate of political independence? And how will the political sphere react when the inflation rate moves too far above or below a comfortable range?
Those are the real questions to keep in mind while investing through the next decade.
Inflation and Deflation, Part 1: The Inflation Chupacabre by Jeffrey Dow Jones
Inflation and Deflation, Part 2: Captain America and the Bond Vigilantes by Jeffrey Dow Jones