The stay-liquid-and-wait strategy

By Felix Salmon
April 19, 2012
National Strategic Investment Dialogue, a fascinating conference attended mainly by big institutional investors.

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I spent yesterday at the National Strategic Investment Dialogue, a fascinating conference attended mainly by big institutional investors. This year featured a lot of scenario planning, especially around the questions of what the best-case and worst-case plausible scenarios might be. At the end of the conference there was a discussion about what it all meant for investment strategies.

I’m not a fund manager, and my investment strategy is unchanged: I’m putting all my money into a target-date fund and forgetting about it. But I gave some thought to how I might behave if I were a fund manager, all the same. And it seems to me that if any time is a good one for a heterodox investment strategy, now could be it.

Much of the time, the best investment strategy is the simplest: buy low, sell high. In the current environment, that would mean buying European and Japanese stocks, while selling Japanese government bonds and Treasuries as well as Brazilian stocks. But that’s a very risky strategy, given that Europe in particular faces a large number of very obvious risks, all of which could send its stock markets falling quite precipitously. And in general, right now we’re in a world where markets have rallied impressively, thanks to the actions of the world’s central banks, and where the risk of mean-reversion is very real. In that kind of context, it behooves the buy-low types to have some safe and liquid securities, like Treasury bonds, which can be sold in a crisis and used to go shopping.

So what’s the alternative? After a day spent talking about how much upside there is if things go right, and how much downside there is if things go wrong, I was reasonably convinced that we’re now closer to a bimodal world than one with thin tails. In other words, the most likely outcome is not that we stay more or less where we are, with [the outcome] becoming increasingly improbable the further you get away from here. Instead, there are two possibilities — up and down — both of which involve substantial market moves, and both of which are just as likely, if not more likely, than a muddle-along-where-we-are scenario.

In that world, an opportunistic wait-and-see approach makes a certain amount of sense: you wait to see which direction the bandwagon is moving, and then you jump on it. You’ll miss the first part of the move, but at least you won’t end up getting crushed.

Liquidity, here, is key — and equities in general are very liquid investments. Here’s the plan, then: sit on a portfolio of large-cap US stocks for the time being, and maintain exposure, if you have it, to expensive, fast-growing markets like Brazil. But look for market moves, and create a list of “tripwire” signs that the waveform has collapsed and we’re moving in one direction or the other. Then, if Brazil falls by 15%, sell it, on the grounds that it could fall a great deal further. (The bearish case on Brazil was one of the more interesting ideas at the conference; it’s related to the country’s cocaine consumption, as well as reports that the Russian mafia now has substantial operations there; a violent Mexico-style drug war is far from inconceivable in Brazil, and could be hugely damaging to the economy.)

On the other hand, if Europe and/or Japan rise by 15%, that could be a decidedly bullish sign. There’s a serious zip-code arbitrage in the world right now: multinational corporations are valued much more highly if they’re based in the US than if they’re based in Europe or Japan. That doesn’t make a huge amount of sense given how global they all are.

In general, if Japan really is managing to bounce back from its torrid 2011, then the stock market there — which is currently trading below book value — could have a lot of upside. Similarly, European stocks have suffered greatly from a decidedly pessimistic economic outlook for the continent as a whole and for the southern periphery in particular. But the continent’s companies might well make good money even if Europe as a whole isn’t growing. On top of that, any further move towards fiscal union or eurobonds could do wonders for investors’ confidence that the eurozone will navigate through this crisis intact.

The one big area to avoid, it seems to me, is any asset class which is both illiquid and expensive. I’d include private equity and venture capital in that class, as well as high-grade debt. There’s really no reason, in a highly volatile world, to be invested in something which can fall a lot and can’t easily be sold. Indeed, there’s a strong case to be made that equities are actually safer than high-grade debt, certainly if your time horizon is greater than a few years. When equities fall, they can bounce back; when rates come back from zero, they’re not going to fall back again. Which means that when investors take mark-to-market losses on their bond portfolios, those losses will be permanent, rather than being on paper only.

I’m not disciplined or rich or sophisticated enough to take my own advice on this: I’d never dream of trying to time the markets, make momentum trades, or otherwise try to be clever in a world where clever investors get eaten for breakfast every morning. But big institutional investors don’t have the luxury of being able to abrogate decisions in that manner. And if I were in their shoes, I’d be looking seriously right now at trying to be as nimble and liquid as possible, which means moving out of credit and into equities. At least that way, if the world really does start falling apart, you have options.


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