Modern Portfolio Theory – the intellectual framework that underlies the methods by which the vast majority of investment managers and advisors execute decisions on behalf of their investing clients – is approaching its 40th anniversary. In a world where anybody with $1000 and an online trading account can buy once-exotic commodities futures, and where US government securities stand not so far from the precipice of a potential downgrade, how well-suited are the assumptions and tools of MPT – fashioned over the last forty years of thought and practice – to the investment challenges of today and tomorrow? MVCM President Masood Vojdani shares his insights gained from thirty years (and counting!) in the investment industry.
I started working in the investment industry in 1981, a year when both inflation and interest rates were stuck in double digits and the conventional wisdom about the equities market was that it was dead. In an age of unappetizing choices for where to put one’s money I learned an early and valuable lesson: portfolio diversification is the smartest way to ensure that when bad things happen in the market you at least have some cushion to limit the downside. Now, diversification may sound like something sensible people have always done since time immemorial, but in fact the building blocks that underlie what today’s professional portfolio managers do for a living were set in place just a handful of decades ago. The cornerstone was a Journal of Finance article called “Portfolio Selection” written by Harry Markowitz in 1952. Markowitz established the basic principles of mean-variance analysis and with that set in motion a fruitful couple decades of advancement in financial theory and practice. This rich period included contributions from William Sharpe (Capital Asset Pricing Model, early 1960s), Eugene Fama and Kenneth French (Fama-French Three Factor Model in the 1970s) and a number of other leading-edge thinkers. The burgeoning discipline that they crafted came to be known as Modern Portfolio Theory.
From Theory to Practice
MPT, as it is known in the trade, had thus already been around in some form for nearly 30 years when I first hung out my shingle as an investment professional. But it seemed to really come into its own as the Great Bull Market of 1982-2000 gathered steam, so to a certain extent I feel like I came of age alongside the movement of MPT from academia’s ivory towers into the cut and thrust of real investment markets. The practical mechanism that effected this movement was asset allocation, which in turn is a somewhat fancy way of saying diversification. Asset allocation is rooted in the two critical measures of Markowitz’s mean-variance analysis: (a) the risk-return characteristics of different types of assets relative to each other, and (b) the level of correlation between different assets in the same portfolio. A whole industry sprang up around the business of making efficient allocation decisions, perhaps best illustrated by the so-called Morningstar “style boxes”. These nine boxes divided the world of stocks into nine flavors from large-cap growth to small-cap value. Pick judiciously among the style boxes for your risk assets, leaven these allocations with whatever percentage of bonds was appropriate for the risk tolerance of a given portfolio style, and you were good to go.
Challenges of the Post-Modern Era
Modern Portfolio Theory has for the most part served the investment industry well; but for two reasons I feel that we may be entering a new – call it “post-modern” – era. The two reasons are: the rapid growth of liquidity-providing financial instruments in an ever-wider spectrum of asset classes; and the increasingly dubious notion that there is a good proxy for a risk-free rate of interest in the market. Let’s look at each of these in turn.
On its face the rise of liquidity-providing instruments would seem like a good thing. Take commodities futures. Back in the 1970s, when MPT was still mostly confined to the halls of academia, it would take a considerable amount of money, sophistication and hard-to-obtain access to a trading platform for an individual to take positions in exotica such as crude oil, soybeans or pork belly futures (remember the movie “Trading Places”, anyone? Randolph and Mortimer Duke were not your typical middle class family with a savings account and retirement plan). Now, for those larger investors (like the Dukes) able to trade in these rarefied markets there were distinct benefits: commodities futures would tend to trade with very low correlation to movements in the stock market. In the late 1970s, for example, equities investors fared quite poorly, while investors in commodities like gold and oil did really well. That changed in the mid-1980s when the stock market rallied strongly while metals and oil prices plummeted. The point is, having the ability to diversify a portfolio across both equities and commodities was a source of value to portfolios of risk assets.
So isn’t it good news that this source of value is now accessible by typical retail investors who live far from the opulent world of Wall Street barons? Yes, to a point. Mutual funds and more recently Exchange Traded Funds (ETFs) have democratized finance. But they have also been at least partly responsible for a noticeable trend in recent years: those low correlation benefits that historical trading patterns produced are disappearing. Commodities futures are now just another so-called risk asset. What markets exhibit now is a tendency to move in and out of risk broadly – not in and out of equities, or in and out of commodities – but in and out of risk. So commodities and equities tend to move in a more correlated pattern than they used to – and the same goes for other risk assets like real estate trusts. This challenges that one important plank of MPT that selecting among different risk asset classes can add value through low correlation.
The Disappearing Risk-Free Rate
While that is concerning enough, I find the second “post-modern” trend even more unsettling. At the heart of practically every valuation technique that has flowed from Modern Portfolio Theory is the notion of the “risk-free” rate of interest. Think of the risk-free rate as a starting point: as you identify and categorize risks that apply to specific assets the investor’s required rate of return moves upwards in increments from the risk-free rate. Investment valuation models usually include some mathematical formula that reflects the idea of “risk-free plus risk market premium”.
For the entire time that MPT has been around the proxy for the risk-free rate has been the US Treasury bond (or note, or bill). The US had established itself as the world’s reigning economy and financial center long before Markowitz’s 1952 paper – that transition really happened when the world went off the Bank of England-centric gold standard in the years following the First World War and never went back. Now US government debt is teetering on the edge of losing its longstanding preeminence, and in the current climate there is even a plausible case to make that the government will at some point in the not too distant future default on certain existing obligations. Whether or not this happens – and I for one believe that ultimately cooler heads will prevail – the fact is fairly indisputable that Treasury debt today substantially lacks the robust “risk-free” nomenclature. It may still be less risky than just about anything else in the market, but that just means that the whole risk curve has shifted upwards and everything in effect is a risk asset. And those time-honored valuation models are rendered much less useful.
Into the Future
At MVCM these problems have been occupying our attention on a constant basis since the market meltdown in 2008. We will by no means claim to have all the answers at our fingertips. But we strongly believe that the investment assets we will be evaluating for portfolio decisions in the months and years to come require different tools than the ones we have become comfortable using over the last thirty years. Post-modern does not have to mean, as it often does in various arts and humanities usages, jarringly chaotic, confusing or depressing. The challenge is to incubate, develop and deploy tools that work within the practical contours of post-modern markets.
In the time-honored Greek myth Pandora, blessed by the gods with abundant beauty and talent but also an overweening curiosity, opens the box and allows all the Ills to pour out into the world. In her despair Pandora quickly shuts the box but by then there is just one thing left inside – Hope.
Hope was in abundant supply today as well as the shares of Internet music company Pandora came streaming into the public securities markets with opening day gains in the neighborhood of 62%. But it is probably going to take more than a wing and a prayer to make it unscathed through the buzzsaw environment of the market these days. Sharing the headlines with Pandora today were the “Zombie Consumers” – a rather stark portrayal by longtime Morgan Stanley economist Stephen Roach of the bleak landscape of US consumer spending in the age of subpar growth, sticky unemployment and debt as far as the eye can see. With the exception of Pandora-mania risk markets today are decisively buying into the Living Dead point of view – the S&P 500 is flirting with its 200 day moving average and testing the 2011 low of 1256 reached on March 16.
Correction territory? Not quite – as of the writing of this sentence the index is trading around 1263, which puts it at 7.2% below the recent high of 1361 attained at the beginning of May. A technical correction requires a downward move of 10% - but that is hardly out of reach given the trading patterns of the past several weeks. “Sell in May and go away” is ringing true as we head into the summer months.
This seems to be the Yogi Berra of summers – “déjà vu all over again”. Greek protesters in the streets of Athens, an internecine war of words between German policymakers and their counterparts elsewhere in the EU, fears of a US double-dip recession consuming bits and bytes of media real estate. No wonder markets got all in a snit last week upon hearing that the Fed has no apparent plans in its head for a quick fix of QE3 to keep the adrenaline rush going. Investors clamoring for more stimulus have a point – if fundamental conditions today are in many important ways little changed from where they were a year ago, then how has the calculus changed away from the need for another round of intervention?
Perhaps it is time for the Fed to take the morphine away and let the natural healing process take effect. Quantitative easing, like any monetary policy, can be at least somewhat effective when applied in measured doses. But it does not make the organic problem go away. The “organic problem” in question here is the fundamentally changed socio-economic conditions of the centers of the developed world economy – the US, the Eurozone and Japan. Each of these centers faces deep-seated challenges to its health unlike any that we have seen since the second half of the 20th century. It is well and good to say that growth engines like China, India and Brazil can pick up the slack and keep global growth humming along, but in reality the fates of the developed and emerging worlds are intertwined. We believe that countries and markets will find their footing – that is the case more often than it is not – but consumer zombies and other unsavory denizens of the night will likely be an ongoing part of the landscape.
Some market corrections are like sudden hysterical meltdowns – dramatic and immediate. They erupt and send everyone to man the panic stations – and then just like that they are over. Investors come wading back in to snap up bargains and the world moves on. Most of the market corrections during the Great Bull Market of 1982 – 2000 were of this variety, most notably the short-lived freefall of Black Monday in 1987.
Other times, though, bear witness to a different kind of correction, and right now we are in one of those times. This is more like a slow-burning funk than a dramatic meltdown. The S&P 500 reached its 2011 high point (to date) back at the end of April. Since then the index, and most other equities indexes, have been stewing in a six week funk. The stock market’s losses have been the bond market’s gains – the Russell 3000 ended June 7 up 3.3% for the year to date, and the Barclays US Aggregate Bond index closed at 3.2% for the same day – virtual parity.
It is worth recalling that this pattern is not entirely different from one year ago, indeed for some of the same reasons. Then, as now, concerns about Greece and other Eurozone tinderboxes were spooking risk asset markets. The global economy was trying to find its footing and getting there in fits and starts. Summer usually means lighter trading volumes than usual, so price trends tend to be accentuated. But there was one significant difference. Last summer the Fed announced its intention to embark on a new plan of monetary stimulus in the form of quantitative easing – QE2. That announcement sparked a rally that took equities and other risk assets sharply higher through the end of 2010 and into this year. Now, QE2 is coming to an end this month. In a press conference on June 7 Fed Chairman Bernanke appeared to stick to the Fed’s position that there will not be a QE3. Markets promptly resumed the slow-burning funk after being comfortably higher for most of the trading day.
The easy answer to formulate from this is that investors lack the confidence to flip the “Risk On” switch without regular fixes from the Fed’s store of steroid juices. There is no doubt some truth to that, but in our opinion that is not the important story. Indeed, the expectation going into yesterday’s Fed conference was that there was no QE3 plan anywhere visible to the naked eye. If Bernanke had suddenly announced a plan it would almost surely have turbo-charged the markets for a day or so, but it would also have meant that the Fed took another look at overall conditions and came to the conclusion that the economy was still unable to stand on its own two feet. Euphoria would have quickly ceded to sobriety and fears that things were much worse than they appear. Analysts would start revising their earnings expectations downwards and market valuations would follow as surely as night follows day.
So here we are with the training wheels off, taking the first hesitant pedals without Uncle Ben keeping the bike steady. If we can keep from falling over in these first few moments, that could be a sign of a more tractable and sustainable underlying strength that could in turn pull risk assets out of their funk.
Just two months ago the beleaguered second-tier European economies were the darlings of global equities. As of March 25 the MSCI Greece country index was up 22.9%, while Spain, Portugal and Ireland were all turning in double digit performances. Their debt problems hadn’t gone away, but investor sentiment appeared predisposed to look on the troubled nations with kindness and favor. For Greece, anyway, that song is over for now. The MSCI Greece index closed on May 24 at -7.6% year to date, thus falling 30% from its springtime highs. Feel like déjà vu all over again? May was crisis month in the Eurozone in 2010, and thus it is again. It’s the same set of problems – a moribund economy with no catalyst for organic growth as far as the eye can see, against a backdrop of global economic uncertainty and a great deal of internecine bickering among EU parties as regards what to do – or what not to do. Of course, when you say that you have the same problems you did a year ago it doesn’t really mean they are just as bad – it means they are one year worse.
The Eurozone debt crisis has not really been a front page issue for most of 2011 – it has been crowded out by numerous other stories of a seemingly more dire nature, from crisis flashpoints in the Middle East to natural (and man-made) disasters in Japan, sky-high oil prices and all the rest. But it has never gone away, and its presence acts as a continual reminder of the fragility in market valuations. The year to date has on balance been kind to risk assets – the Russell 3000 is up around 7% – but it has not been the kind of solid performance that inspires confidence. Indeed, many of the market’s bright spots so far in the year have been in those European equities markets. The MSCI EU index is still up 7.2% year to date, but the luster seems to be fading that region. Japan is already dragging broader developed international indexes lower – the MSCI EAFE index is up only 2.4% year to date largely because of Japan’s weakness and generally lackluster performance so far in the developed Asia Pacific markets of Singapore, Hong Kong and Australia (New Zealand, oddly enough, is doing quite well in comparison to its regional brethren). And emerging markets in general have been having a bumpy ride of it so far this year, with the key growth markets in a bit of a holding pattern and the usually dynamic regions of Asia and Latin America trailing the broader indexes.
In the US the performance leaders continue to be in midcap generally and in growth over value. Interestingly, though, the Russell 200 Megacap index and the Russell 2000 Small Cap index have just traded places for the first time since January, with megacaps now turning in a slightly higher performance for the year to date. There is no small contingent of US equities investors who would love to see their long-awaited megacap rally take place – it’s been a case of Waiting for Godot for longer than any of them would care to remember. Time will tell. The economic picture continues to be muddled – housing figures and durable goods numbers posted this week were underwhelming, the consensus economics forecast is below 3% again (it was around 3-3.5% at the beginning of the year) and the jobs outlook continues to be muted even though weekly jobless claims have continued to fall. It may well be time to recall the time-honored adage: Sell in May, go away. Or not.
It’s not like we didn’t have enough to worry about, after all – tepid economic growth, budding asset bubbles in debt and commodities, and sundry debt crises are more than enough thank you very much – so why did the head of the IMF have to go and wind up on suicide watch in Rikers Island jail? Dominique Strauss-Kahn may not have much in the way of judgment-exercising capabilities in his personal life, but by all accounts he has been a linchpin figure in the protracted financial problems in the Eurozone, reputed to be just about the only financial policymaker to whom German Chancellor Angela Merkel will listen. This is not a good time for yet another X-factor to suddenly emerge from its quantum superposition into our observed reality – but here we are.
It is a measure of Strauss-Kahn’s success in managing the process of dealing with the Eurozone debt crisis that it has largely stayed off the front pages of the financial media and has failed to spook equities markets unduly. But the lack of visibility does not by any means indicate an imminent resolution. The fixes applied to keep Greece and Portugal from going over the edge are wobbly, and the kind of organic economic robustness that would improve the competitive positions of second tier European countries is not visible to the naked eye. Tough decisions will have to be made in the near term, and Strauss-Kahn has shown himself to be that rather rare specimen of technical bureaucrat with the force of personality to make the tough decisions. All the more pity that the “force of personality” was so completely and inappropriately directed as pertains to his off-duty adventures.
What are the immediate implications for market performance? Well, as we noted above, anything that adds to the already potent cocktail of volatility is most unwelcome. Assuming that regardless of how his legal predicament works out, Strauss-Kahn has put himself beyond the pale as a viable ongoing leader of the IMF, it may be some time before we fully appreciate the practical implications of his stage exit for the Eurozone. But turning up the volatility dial can accelerate what we see as in high probability the biggest concern in markets today – the expanding bubble in debt and commodities prices. Energy, metals and agriculture prices have tumbled in recent days but continue to spike up and down by large leaps on a daily basis. Yields on the 10-year Treasury note are down about 12% from their levels three months ago, leaving one to wonder what pixie dust can continue to sprinkle over government debt markets to keep their prices from going into a severe nosedive. Curiously, when you look at market performance in the year to date the most stable returns trends seem to be in equities. That could of course change on a dime if the froth in other asset markets continues to build up. The probability of a very bumpy second half of the year appears to be gaining ground. It is indeed a shame that one of the better financial policymakers out there had to take himself out of the action in such an ungainly manner.