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Everything Old is New Again

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I recently received an email from an advisor who took issue with much of the premise behind my November 2011 Investment Advisor column: “Not Your Father’s Commodity Investments.” It seems he disagrees with my notions that we seem to be in a dramatically new market compared with the one we’ve grown used to over the past 25 years, and that the old market continued on through the dot-com crash to end in July 2007. While it’s true that following markets is often like reading tea leaves, it sure seems to me that we’re in the middle of some dramatic economic changes that have long-range implications for the way independent advisors manage client portfolios—and possibly for the independent advisory industry itself.

First, here’s his side of the story: “You say ‘the use of short selling … allows fund managers to generate positive returns regardless of which direction commodities markets are trending.’ I would think that also means that they can generate negative returns even if commodities generate positive returns. Also, I’m confused by ‘…during the 25-year bull market, there hasn’t been much need for alternatives. […] Now the ride up seems to have come to an end.’ We are in a 13-year sideways market, so unless your November 2011 article was actually written 12 years ago, alternatives have been a great place to be over the past decade. My clients have benefited. But to say that now the ride up seems to have come to an end is ridiculous: For the last three years we have seen fear and panic, but stocks are up nearly 100% during that time. In general, stocks look extremely attractive now with rising dividends, strong earnings, clean balance sheets, etc. Why is the ride over? I would be a contrarian here and say that those who thought they found a better mouse trap with things like managed futures a few years ago have been sorely disappointed and that in a choppy market, trend-following will be a lousy strategy.”

Here’s the funny thing about markets: If stocks fall, say, 80% during a given period and then go back up “100%,” you’re still out 60% of your original value. In more realistic terms, from its all-time high in July 2007 to the mortgage meltdown bottom in January 2009, the S&P 500 fell from 1,527 to 798, down 729 points or 47.7%. Then, from that 2009 bottom to Jan. 20, 2012, the S&P did indeed claw its way back to 1,315, up an amazing 517%. Unfortunately, that means buy-and-hold investors are still down 13.9% from the 2007 market top, some four years later, an annual loss of 3.6%—tough to build a retirement portfolio on numbers like that.

What’s more, by strategically picking peak to trough, many so called “bull markets” can be made to appear flat. For instance, from July 2002 to the market high in July 2007, the S&P grew from 815 to 1,527, an increase of 87.4% in five years. But from the pre-dot-com crash high of 1,499 in January 2000 to the 2007 high, the market only grew 28 points or 1.9% over seven years. When it comes to the stock market, truly, much is in the eye of the beholder, so it’s helpful to look at longer trends for a bigger picture of what’s really going on.

A longer view shows a very different picture. For the 12 and a half years from January 1995 to the July 2007 market top, the S&P grew from 501 to 1,527, or 205%. That means a well-allocated buy-and-hold client made an average annual return in the 9.75% range on the equity portion of his portfolio, despite the dot-com crash and the devastating 9/11 attacks. What’s more, for a really long view, from April 1982 to the all-time S&P 500 high in 2007, the market went from 109.6 to 1,527, up 1,417 points or 1,288%. That’s an average annual gain of 11.1%, year in and year out, through ups and downs and including market corrections in ‘87, ‘91, the dot-com crash and 9/11. These are the returns that the modern independent advisory industry was built on.

In my view, since 1982, the U.S. markets have shown a remarkable resilience. Many economists attribute this to the fiscal responsibility initiated under Reagan and Volker in the form of low interest rates, low taxes and relatively controlled government spending and government intervention. Unfortunately, the erosion of these bull market underpinnings began under George W. Bush and has been greatly accelerated under the current administration, to the point where high government spending and intervention, combined with the threat of much higher taxes and resulting higher inflation and interest rates, have prevented our economy and the markets from making a robust recovery for the first time in 30 years. The market gains over the past three years have come with unprecedented volatility for a recovery, including two mini-bear markets (between January 2010 and April 2010, the S&P fell 12.1%, and from January to July last year, it fell 14.7%), at trading volumes that are above 4 billion trades per day—a level never seen before 2008.

Consequently, again in my view, it’s very likely that the 25-year bull market (from April 1982 to July 2007) that has been the driving factor behind the meteoric rise of independent financial advice, based on buy-and-hold, equity-centered portfolio management, has come to an end, for at least some years to come and possibly a lot longer than that. (Remember, in the late ‘60s, ‘70s, and early ‘80s, we had almost 20 years of a flat stock market.) To my mind, this also suggests an end to financial advisors’ ability to simply build static portfolios and occasionally rebalance them into financial success for their clients. In a trading-range market, everyone’s not a winner. Of course, many advisors have come to this conclusion as well, which has led to the most interest in non-correlating “alternative investments” that I’ve seen since the early ‘80s.

Which brings us to commodities. Again, back in the early ‘80s when I started covering financial advisors, a “well-allocated” portfolio held real estate, oil and gas, and gold. Why? Because the equity markets had been flat for most of two decades (From October 1968 to April 1982, the S&P 500 rose from 103.9 to 109.6, up 5.7 points or 5.5% in 13 years, an average annual increase of 0.4%.), while inflation was in double digits. However, as we also saw in the mid ‘80s, commodities are not a buy-and-hold investment to be simply plugged into risk-adjusted static portfolios. Neither are many of the other alternative investments and strategies that today’s advisors are considering. That means to generate real returns for clients in our new economic reality, advisors are going to have to know a lot more than how to identify “hot” mutual fund managers. They’ll have to monitor both economic and market factors, in markets beyond stocks and bonds.

Or they can utilize the skills developed over many years for identifying good investment managers and broaden their scope to include managers of alternative investment vehicles such as commodities funds. This, of course, means adding some risk to portfolios: the risk of market positions in addition to simply the securities selected. And, as the above advisor pointed out, this will mean you can lose money in up markets as well as make money in down markets. But it also means adding an inflation hedge, which appears to be necessary for the first time since 1984.

Are commodity funds or any other alternative investment or strategy worth the additional portfolio risk? Seems to me the better question is what’s the alternative (no pun intended)? With many baby-boom clients needing to make substantial portfolio returns to meet their retirement goals, a flat or very volatile stock market plus inflation-dampened bond returns aren’t going to cut it. It’s a difficult adjustment for advisors who have to come to rely on buy-and-hold, equity-and-bond, style-box-centered, static portfolios. But if the economic game has really changed, as I fear it has, it will require dramatically new—and old—strategies.


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