Wednesday, June 12, 2013

Now Is Always the Most Difficult Time to Invest

I have heard that saying somewhere. A few weeks ago, I wrote an open-ended post that reflected this uncertainty. I wasn't sure of whether to load up more aggressively or lighten up on stocks. I used to think that this kind of strategy is somewhat like trying to time the market. And I know I cannot and should not try to do that.

But recently, upon reading Benjamin Graham's books again. I realize his conservative strategy is really centered on the allocation between bonds, which reflects a pessimistic view, and stocks, which reflects a bullish view. Graham says that one should allocate between 25% to 75% stocks, with the remainder in bonds. In bullish times, when stocks are undervalued, he would allocate closer to 75% stocks. In times when stocks are more speculative, he would allocate closer to 25% stocks. This has the effect of moderating the big returns in bull markets and mitigating the huge drops during bear markets. The net result of this is better return in the long term which is over cycles of bull and bear markets.

I want to follow this strategy because I don't have a crystal ball as to the direction of the market, especially now. In fact I don't even know whether stocks are overpriced or not. But if I am forced to take a position, I'd say we are most likely in an overpriced market right now.

I am not a financial guru on market valuation, so I look to others for guidance. The mutual fund filings are a good source of information. But the funds must be balanced funds that hold both stocks and bonds. My only fund holding is the Bruce Fund. I have a lot of respect for this fund because of its staying power over 30 years. They say past performance is not guarantee of future gains. But I believe the Bruce fund has the best idea of how to handle the current market. So I look back over the last 15 years when the annual reports are available on the SEC website. The following chart shows their bond and cash allocations over that period. The remainder of their fund was invested in securities, including common, warrants and preferred shares. The chart shows the bond position from the safe portion (cash) to the riskier portion (corporate bonds).



One can see how the Bruces correctly called the recession of 2000 and 2008. The fund's cash and the safer government bond positions were high in the periods before 2000 and 2006-2007. I believe this is the key to the Bruce Fund's outstanding return. But most important goal of this exercise is to figure out what to do now. It is appears that the Bruce Fund is in a holding pattern for the last 4 years. The fund is cautious but not so much like the periods before the last two recessions.

Warren Buffett is another great investor who likes to keep a cash hoard as insurance for a rainy day. His cash position is substantial but difficult to interpret as he has a big conglomerate and insurance business to run. Seth Klarman of the hedge fund Baupost is another defensive investor and he has recently said he keeps more than 30% cash.

But there there is also some compelling arguments to the opposite view that this is the time to allocate more to stocks. The current overall investor sentiment just isn't strong. The current market is full of investors running scared. Since 2009 investors have been consistently moving money from equities to bonds. Furthermore, the consumer confidence index is at 70, which is still below the normal 100 of the pre-recession days. These are contrarian indicators that makes it hard for me to imagine a bubble and the inevitable crash.

Another compelling data point is the graph I posted earlier. The graph shows the 10-year cyclical adjusted PE , the 10-year treasury yield and the inflation rate. A high inflation rate forces a high interest rate. But today we have the enviable position an of big government stimulus without high inflation and without high interest rate. And, for this reason, Fran├žois Rochon of the Canadian Giverny Fund then concludes: "We believe that equities will be the best asset class in the coming years for the simple reason that it seems to be the most undervalued."

So there you have it, both sides of a compelling argument. Never is the adage that now is the most difficult time to invest been so true.

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