After his “sure bet” against the deutsche mark temporarily wiped him out in 1920, John Maynard Keynes famously quipped, “The market can stay irrational longer than you can stay solvent.” Maybe it’s a result of globalization, but irrational financial markets seem to carry a bigger wallop today. To update the cliché, when the United States (or China or the eurozone) sneezes, the whole rest of the world now catches pneumonia.
Is there a prudent way to play irrationality? We think so. We call it the convergent and divergent strategy. It’s one that is poised for both rational and irrational markets. It transforms the traditional long-only portfolio, with its classic 60% equities and 40% bonds allocation, into a meaningful allocation to alternative investments, perhaps including long/short equity, long/short fixed income, managed futures and global macro strategies. It takes the advantages of diversification into a new sphere. Instead of diversifying by peppering the portfolio with different asset classes or geographic areas, it also relies on a combination of alternative investments that go long and short based on both fundamental and non-fundamental factors such as technical price movement, behavioral tendencies and geo-political expectations, among others.
A majority of investors’ portfolios are focused on convergent strategies. They adhere to the idea that the intrinsic value of an asset can be measured using fundamental data like projected earnings and dividends. They believe markets are efficient most of the time, but that on occasion, they aren’t. So they search for those instances when, say, IBM is overpriced or underpriced, buy the stock and wait for its price to converge to its fair value. Most traditional long-only strategies are convergent, as are long/short equity strategies, albeit with greater flexibility, including the ability to short.
A divergent strategy, by contrast, is agnostic to the concept of fair value and is capable of generating profits during periods when fundamentals may not matter. If Iran’s nuclear facilities were bombed tomorrow, would investors care about IBM’s intrinsic value? Unlikely. Remember the accounting scandals in 2002 with a big emphasis on WorldCom? Value investors fought the markets for months as their standard metrics for security selection simply did not matter. Headlines were dominated by the movement of stock prices as investors overreacted to company news and rumors for fear of manipulated accounting practices.
The biggest recent divergence occurred as a result of the 2008 credit crisis. Panic completely trumped fundamentals. Between March 2008 and March 2009, for instance, IBM stock price plunged by more than 25%, even though very few of its fundamentals had changed. To the contrary, IBM reported over several quarters that it had not been affected by the crisis and that its earnings were growing. By the end of 2009, IBM’s stock price had converged to $130.