Archives for November 2017

One major question in portfolio construction is how to allocate between US stocks and non-US stocks. Over the last 10 years, US stocks have outperformed International stocks significantly. However, as the following chart shows, they tend to take turns outperforming each other in cycles:

Chart is from Factor Investor, found via Abnormal Returns.

This is not a recommendation for market timing, as for starters you don’t know how long each cycle will last. For me, it is more of a visual reminder of why you might choose to diversify between US and non-US stocks. You don’t need as much as I do, but I think some is prudent. Things may not look great internationally right now, but that’s why valuations are also much lower, which in turns sows the seeds for a future bull market. Are you okay with your portfolio if the cycle shifts again?

There seems to be a lot of angst about the stock market these days. It’s been going up, up, up. Is it too high? Will there be a crash? Accordingly, I just caught up on the most recent Howard Marks memos – There They Go Again… Again [pdf] and the follow-up Yet Again?. Everyone from Warren Buffett on down reads these memos to Oaktree Capital clients.

The first memo contains mostly cautionary advice about how asset prices are high, prospective returns are low, and high-risk behavior is commonplace. We are in the midst of high uncertainty in terms of central banks, politics, technology, future jobs, and more. Yet stocks are at historically high-valuations and risky bonds (junk corporate, emerging markets) are priced at historically-tiny premiums to Treasury bonds.

A common explanation for these thing is that interest rates are low, so the prices of stocks and bonds are justifiable. Therefore, I found this quote interesting:

The bottom line is that while the prices and prospective returns on many things are justifiable today relative to other things, you can’t eat (or spend) relative returns.

In other words, just because you can justify it doesn’t mean you should buy it.

The second memo tries to respond to criticisms and also provide additional guidance. It’s easy to point out flaws. It’s harder to lay out clear and actionable advice. Investing in low-cost index funds is not perfect and has many drawbacks. But what is better?

What should an investor actually DO with high asset values everywhere? Marks offers the following choices:

1. Invest as you always have and expect your historic returns.
2. Invest as you always have and settle for today’s low returns.
3. Reduce risk to prepare for a correction and accept still-lower returns.
4. Go to cash at a near-zero return and wait for a better environment.
5. Increase risk in pursuit of higher returns.
6. Put more into special niches and special investment managers.

For the most part, he dismisses #1, #4, and #5. This leaves:

For me the answer lies in a combination of numbers 2, 3 and 6.

After digesting these Howard Marks memos, here are my personal takeaways and opinions:

• Adjust your future return expectations to be lower than historical averages.
• Make sure your portfolio is stress-tested. If a 50% drop in your stocks would freak you out, then reduce your risk slightly by selling a bit of stocks and buying a bit of short-term, high-quality bonds (or cash). Don’t go 100% cash, but do take some risk off the table if necessary.
• You might simply keep your portfolio the same. I’m sticking with 2/3rd stocks (globally-diversified) and 1/3rd bonds (on the shorter-term, higher-quality side).
• If you are Howard Marks, you might look for “special niches and special investment managers”. If you are not Howard Marks, ignore this option because you’re most likely to do harm than good. If anything take 5% of your portfolio, manage it however you like, and compare your return honestly with your index funds.

Here’s a good quote from a 2007 memo as to the consequences of being cautious:

If you refuse to fall into line in carefree markets like today’s, it’s likely that, for a while, you’ll (a) lag in terms of return and (b) look like an old fogey. But neither of those is much of a price to pay if it means keeping your head (and capital) when others eventually lose theirs. In my experience, times of laxness have always been followed eventually by corrections in which penalties are imposed. It may not happen this time, but I’ll take that risk. In the meantime, Oaktree and its people will continue to apply the standards that have served us so well over the last [thirty] years.

Risk-taking in the capital markets is becoming widely accepted again. Therefore, the contrarian thing is to not increase your risk right now. You may have to give up some possible return, but it is wiser to be prepared. Marks is not a “perma-bear” that always call for an impending crash. If you read the Barron’s cover above it quotes Marks as saying “stocks are cheap” back in March 2013 (paywalled article). Not a bad call in hindsight. Bookmark this article for another hindsight check in 2021/2022.

You can read previous Howard Marks Memos online for free, or as a book with extra commentary in The Most Important Thing.

The Vanguard Blog has an interesting scatter plot of annual stock and bond returns from 1926-2016. The vertical axis is bond returns (broad US bond indexes), with the blue shaded areas indicating bond returns between 3% and 7%. The horizontal axis is stock returns (broad US stock indexes), with the purple shaded areas indicating stock returns between 8% and 12%. Click to enlarge.

I don’t remember seeing this data presented in such a manner before. I think this is a good chart to keep in your head. Here’s why:

While we often keep an idea of “average” in our heads, the actual return in any given year could be all over the place. You could also have low stock returns and low bond returns, or high stock returns and high bond returns. It’s much more common to be “not” average than average.

Stock returns are much wilder than bond returns. Bond returns were in the 3% to 7% band only 30% of the time (27 out of 91 years). However, stock returns were in the 8% to 12% band only 7% of the time (6 out of 91 years). Also, the bond scale only goes from -5% to +35%. The stock scale goes from -50% to +60%.

While I liked the graphic, I didn’t really agree with the text of the linked post. Neither “desired return” nor “required return” would seem to be good benchmarks. The market doesn’t care what you want or need. You take what you get and you deal with it. I think using an appropriate Vanguard Target Retirement or LifeCycle all-in-one fund as a benchmark is reasonable because it is a real-world alternative to whatever custom mix of investments you decide to hold. Such a benchmark can help keep you honest with yourself.