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Regarding your May issue, isn't predicting a crash just another form of timing the market? Haven't you lectured against that?
As we have noted in the past, we have a mixed view of attempts to time markets, by which we means varying the asset class weights in a portfolio after they have initially been set. We distinguish between four types of market timing, depending upon whether their objective is to earn higher return or reduce risk, and whether they are undertaken systematically or episodically. Systematic market timing most often takes the form of a regular rebalancing strategy. Rebalancing back to target weights based on some criterion (e.g., the passage of time, or one asset class hitting a "trigger level" above or below its target weight) is intended to limit risk. In some of our model portfolios, we also incorporate a second approach (rebalancing the most overweight asset class to below its target weight, and the most underweight asset class to above its target weight) that is intended to add incremental returns by exploiting markets' tendency to overreact and then mean revert. An alternative systematic market timing approach whose goal is higher returns could take the form of a tactical asset allocation strategy that alters asset class weights (e.g., within a range defined by the target weight plus or minus 5%) based on some systematic calculation (e.g., recent trend compared to a moving average, or relative valuation indicators).
Episodic market timing does not happen automatically according to a predetermined decision rule; rather, it is undertaken based on an investor's consideration of a number of situational factors, and the conclusion they imply about relative asset class valuations or the level of systematic risk and fragility present in the global economy and financial system. Again, the primary objective of episodic market timing can be either higher returns or lower risk. In our view, given the overwhelming evidence that relative returns are less stable over time (and therefore more difficult to forecast) than risk, we believe that episodic market timing efforts are best focused on the latter. Specifically, when pursuing multiperiod investment objectives (e.g., funding a liability or not running out of money while meeting a bequest target), avoiding large losses is arguably more important that reaching for the last 50 basis points of return (since the exposure to downside risk typically increase more quickly than the incremental expected return).
We recognize that what we wrote in our May 2007 issue violated our general policy of diversifying across a wide range of asset classes and following a systematic rebalancing strategy. We tried to emphasize the point that this policy was predicated on an assumption of relatively normal economic and market conditions and that what we fear is on the horizon is a multi-standard deviation event that formed the basis for our episodic market timing conclusion. A large number of readers wrote to us; some agreed and some didn't - but most appreciated our willingness to make a clear call. As one reader from the U.K. wrote, "At 63 my time line means I no longer have a comfortable 10 to 15 years to recover serious asset erosion. I'll take satisfactory gains now, thank you, batten down the hatches and be ready to ride out whatever storm materialises. What serious upside potential might I miss? Of course I'm retaining some very good assets in various classes and my cash will undoubtedly buy some much better deals down the road and allow a better re-allocation into the bargain. And if I'm wrong? Well, my investment journey will continue peacefully in sunshine and I'll be ready for new opportunities, well rested, because I'll have slept less fitfully!"
On the other hand, a reader from Germany wrote to say that "When markets make radical moves, investors demonstrate either the courage or the cowardice of their convictions....However, I still believe that long term asset allocation is more promising than short term market timing...and it is prudent to stay invested." As we wrote last month, we did not make our recommendations lightly, nor did we expect them to be non-controversial. But, to get back to your question, we do believe there are circumstances under which episodic marketing timing is justified, and that this is one of them.
Looking for other views, I found the IMF's most recent semi-annual Global Financial Stability Report (GFSR) dated April 2007. The report mentions all of your concerns (I think) and concludes "while the downside risk from a possible disorderly unwinding of global imbalances has receded somewhat, it remains a concern." I hope the GFSR is included in your reading.
It certainly was. We also highly recommend Miranda Xafa's IMF Working Paper titled "Global Imbalances and Financial Stability" for an excellent overview of the arguments on both sides of this issue (available at: www.imf.org/external/pubs/ft/wp/2007/wp07111.pdf). And we agree that, with respect to the timing of the major global correction we see as the inevitable result of many trends underway in the world today, there are, to quote former U.S. Treasury Secretary Lawrence Summers, a lot of "chastened prophets" who expected said correction to have occurred well before June 2007. That being said, the evidence in favor of an eventual severe correction is also out there - to cite but two examples, the world's central banks are now financing a very large portion of the U.S. current account deficit, as private investors (and indeed, some central banks) have begun to diversify their holdings away from the U.S. dollar. In this regard, the timing of the eventual correction has become as much a strategic political decision as an economic one. Moreover, we need look no further than Japan for evidence that severe corrections can produce prolonged and very painful economic slumps (which, if said slump occurred in the United States, might work to the long-term strategic (if not short term economic) benefit of some of the countries now financing its deficit). As we said, given these circumstances, we believe that the most prudent course of action is to leave the party a bit early, rather than staying to the bitter end.
Given that market timing is a wash, how do we manage a move to all cash? Do we stay out of the market indefinitely? I do not doubt the thinking in the May 2007 edition, but it does lead to some difficult questions. What about the use of structured products to protect against loss but continue with market involvement? Wouldn't this solve the problem for the near future?
There is undoubtedly a happy medium between moving more into cash (e.g., by reducing exposure to particularly overvalued asset classes like equity and probably property) and other defensive investments (e.g., timber; and unhedged foreign currency bonds for U.S. dollar based investors) and using structured products (e.g., buying and rolling forward equity index puts) to accomplish the same ends. In our view (and this comes from someone who started buying equity puts in late 1998), while cash is definitive, it leaves open the question of when to get back into an asset class (e.g., when the valuations appear more reasonable). On the other hand, while structured products avoid that decision, the prolonged cash outflows they require can generate a lot of second guessing and sometimes cause investors to "throw in the towel" and abandon the hedge just before the anticipated (and inevitably delayed) correction finally occurs. We don't think there is any single right answer to this tradeoff - but structured products are clearly an option.