Opinion

Felix Salmon

The stay-liquid-and-wait strategy

By Felix Salmon
April 19, 2012

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.

Comments
14 comments so far | RSS Comments RSS

I’m not terribly sophisticated, and I’m only managing (or advising) a couple million dollars, but I’ve been emphasizing high-quality multinational equities. “Blue chip” stocks if you like. They will fare well in a crash (even if the price drops, the cash flow and dividends will continue), yet they will capture most of the gains in an extended bull market.

Sold off assets last year to pay off the mortgage, however, so there will be extra cash coming in to take advantage of any bargains that might present themselves. I agree that liquidity is valuable right now.

Posted by TFF | Report as abusive
 

For individual investors, understanding you own financial situation is much more important than trying to figure out what the market is going to do. Too many investors focus on maximizing return…not enough on minimizing risk.

Right now, any money you may need in the next five years should be in cash/cash-equivalents…the only money that you should have in the market is money you are not going to need for a long time.

Posted by mfw13 | Report as abusive
 

This is just market timing wrapped in some fancy jargon. Figure out what markets are cheap (Europe mostly), buy them, and don’t look at your account more than quarterly.

Stop conflating asset price volatility with risk

Posted by topofeatureAM | Report as abusive
 

Hey Felix – any good links on those Brazil issues? Or perhaps more detail in an upcoming post :)

Posted by the_poqit | Report as abusive
 

Agree with topofeatureAM that you just described standard market timing based on momentum and macro “feelings” that retail investors often try pursue (and usually fail miserably).

Posted by techer | Report as abusive
 

So a stock market with P/E ratio of 7 — Brazil (BOVESPA) is expensive? Duh.

Posted by stannys | Report as abusive
 

>I’m not disciplined or rich or sophisticated enough to take my own advice on this

Rich has nothing to do with it, but you probably got the other two adjectives right. There are people who can trade and those who can’t. Someone who avoid European and Japanese stocks now because of the risk of them falling in value is clearly in the latter category of undisciplined dumb money that tends to buy high and sell low. Buying stocks is ALWAYS setting yourself up for a nasty surprise. That’s why the equity risk premium exists. Individual investors, other than those like Buffett who are so rich as to be beyond caring, should always feel worried when they trade hard cash for stocks. In some people, worry is actually a very good barometer of when to buy–buy when you feel fearful, sell when you feel greedy. Buying back in October 2011, for example, made me feel literally sick in my stomach. By contrast, I’m now feeling greedy and not at all worried about buying US stocks, which is precisely why I’m NOT buying US stocks now. I’m very worried about the European stocks I currently own, which is precisely why I’m not selling those stocks now.

Posted by revelo | Report as abusive
 

Jeremy Grantham’s latest letter is thoughtful and worth reading (agency costs and market inefficiency) but Ben Inker’s two page note at the end is directly applicable to this post: stay liquid and wait is a sensible approach when asset prices are being artificially inflated by central bank policy. As Seth Klarman says, cash is an option on the future.

http://www.gmo.com/websitecontent/JGLett er_ALL_4-12.pdf

Posted by Sunset_Shazz | Report as abusive
 

Buy big international stocks that are cheap. Tesco for instance would be my choice. PE below 9.

Posted by Chris08 | Report as abusive
 

And for those not willing to stay liquid, and willing to invest and start a business now look at business for sale listings on http://www.businessforsale.com

Posted by michellebfs | Report as abusive
 

Felix… “I’m putting all my money into a target-date fund and forgetting about it.”

A man in your position could reasonably expect to have twice the money when he turns 70 if you took an active interest in your investments… think of all the aged grape juice you could buy with the differnce.

Posted by y2kurtus | Report as abusive
 

Cash is king period when the market has a profound correction due to systemic problems like we may be facing in Europe. Blue chips got crushed in 2008 as did every other class of U.S. equity. Look at the historical charts. Equity indexes around the globe were crushed in 2008. There was no place to hide…except in cash. I sold all of my equities the Thursday before Bear Sterns announced it was insolvent. I figured Bear was the Canary in the coal mine and if Bear could go under any of the big NYC firms could go under. I sat on the sidelines in cash and watched the bloodbath. I waited until the Dow bounced off the Mark Haynes bottom and went all in at Dow 8,000 then more than tripled my money. Once the Fed pulled the plug on the artificial stimulus that was inflating equities I sold everything and hit the sidelines. I’ve been patiently waiting for the problems in Europe to cause another significant market crash. Cash is the place to be if you really believe Spain, France and Italy have troubles that will cause systemic panic in the financial system. When you look at Italy’s government debt load it’s hard to see a way out for them absent a controlled default similar to that of Greece but wiping out 75% of the capital of Italian Bond holders would rock world markets. You can’t be invested in equities and avoid being crushed in 1,000 point flash crashes and 600 point daily drops. Cash is king when the stock market is about to implode.

Posted by Talking_Head | Report as abusive
 

Talking_Head, good points on that, but market timing is tricky…

I’ll stick with the formula that got me through the 2008 crash cleanly (losses in 2008 evenly balanced by gains in 2009). Quality combined with opportunistic buying.

Posted by TFF | Report as abusive
 

Staying liquid in the face of rising but overvalued share prices is one of life’s challenges. Investing in small unlisted businesses can often offer healthy returns if you have pre-existing knowledge in the sector and don’t mind getting your hands dirty – wwww.businessforsalefinder.com

Posted by Jwhite84 | Report as abusive
 

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