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Investing during market turmoil

The idea that considers equity investing as long term has simply become absurd nowadays and has been so during the last 10 years. Let us be reassured. Opportunities will still be around…

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Beyond the market turmoil taking place during this summer of 2011, the idea that supports long term equity investing which stems from the probability of gaining from profitable corporate performance (which will eventually provide a positive return on investment) has simply become absurd nowadays and has been so during the last 10 years. We can easily get confirmation from the investors which have suffered from the dot com crash back in 2000. We need to be aware nowadays that investing on some securities will possibly require us to review their prices in 10 years due to unfavorable regulatory and demographic evolutions that impact equities.

Overall, an environment which is prone to risk aversion, regulatory evolutions and an increase in systemic risks must lead us to review portfolio management. Let us be reassured. Opportunities will still exist for those who will have the courage to flee unilateral thinking, politically correct behavior and central scenario consensus (we can see where this has led us nowadays). In brief but not as simple as it sounds (since we are all subject to institutional constraints), for all those who prefer being right alone than wrong with everybody else. And, by quoting one of Moneyweek’s favourite expressions, for those who will have understood that “when everybody thinks likewise, nobody is thinking”.

The only real question nowadays is how to allocate between real assets and financial assets
Mory Doré

Since traditional reasoning on financial asset allocation is being blown apart, the question is no longer about overweighting equities or underweighting bonds. The real question nowadays is how to choose between real assets and financial assets. If in the ancient world, it was unanimously agreed that a portfolio would consist of 10% real assets and 90% financial assets, isn’t it time to consider a real revolution and – that is still at an intuitive stage – recommend an allocation that would bring a portfolio to target 60% of its investment in real tangible assets and only 40% in financial assets.

REAL ASSETS

Within the 60% invested in real assets, we can imagine the following allocation:

- 1. Gold, silver and other commodities (mining and agricultural) that would represent 20% of the portfolio while ETFs and synthetic trackers would be avoided (Decorrelation risk between real exposure and official indexation). Physical gold and carefully selected commodity shares would be privileged. The timing should also be properly considered in that a technical correction in gold’s price will be sought as well as a decrease in the fear of a worldwide recession before reinvesting in commodities.

- 2. Inflation linked bonds issued by top notch sovereigns (20% of portfolio) since inflation will gradually intensify worldwide. Several inflation factors can be identified among which we can include commodity prices, a rise in emerging markets’ wages, public debt monetization by central banks with a third round of quantity easing by the fed and finally a first round of quantitative easing by the ECB that would not include liquidity recovery.

- 3. 20% of the portfolio invested in real tangible assets most notably on SCPIs with a proven track record. SCPIs are investment vehicles designed by French authorities that enable their holders to purchase real estate shares

FINANCIAL ASSETS

The remaining 40% of the portfolio that would be invested in financial assets are harder to distribute.

- We can imagine a monetary cushion that would take 10% of the portfolio and which will not yield anything (It does not matter if the cushion is in USD or EUR since short term interest rates will not increase anytime soon as confirmed by the Fed which has signaled its intention during the FOMC held on the 09/08/2011 of keeping them low until 2013! GBP, CHF and JPY fall in the same category) but which will keep the capital intact.

- 10% on government bonds having a maturity of less than 3 years The bonds would be on those governments still considered risk free (Core Euro zone and to a lesser extent UK and US bonds despite the decision from S&P)

- 10 % only on risky assets by taking into account sound fundamentals which are represented by pricing power for equities and the financial structure for bonds. This will require us to be very selective on some equities, convertibles, investment grade corporate bonds and high yield OCDE as well as emerging market sovereign and corporate risk.

- 10% remain for us to optimize our financial management and generate return on highly liquid alternative assets and diversification vehicles (this would take the form of directional trading or arbitrage strategies under direct management or under delegation depending on investor maturity). As far as I’m concerned, I am thinking about forex with bets which are adapted to specific market conditions :

  • Long positions in CHF and JPY against all other currencies during periods of strong risk aversion and heavy drops in equities (as was the case recently; we should however be careful about currency interventions that can happen in several ways from the Bank of Japan and the National Bank of Switzerland)
  • In an opposite market configuration when risk aversion is going down and equity indices as well as commodities are going up, the weightings of the three dollars (Australian, Canadian and New Zealand) would be increased
  • The three major currencies which are the GBP, the Euro and the USD are not the best vehicles to benefit from those market environments even if the USD usually benefits a bit more from risk aversion than the other two currencies (but less than the CHF and the JPY). The Euro and the GBP are generally penalized by a rise in risk aversion (but less than commodity currencies)
  • It should be noted that forex bets should not be exclusively based on market psychology and risk aversion. They must, especially when the three major currencies are being considered, take into account specific situations (US sovereign debt rating, sovereign debt crisis) and the anticipations on the evolution of central bank monetary policy.

Mory Doré , August 2011

Article also available in : English EN | français FR

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