I have been meeting with clients over the last few weeks and it’s hard not to notice the similarities in questions that come up, specifically regarding the conservative positioning reflected across our portfolios.
In Bob Swanson’s recent podcast, he discussed the positioning within the Cambridge Asset Allocation Corporate Class portfolio, which I can expand on here. Our performance has been muted versus some indices this year, largely as the result of our conservative positioning—about 45% equities, 49% fixed income and 6% cash holdings in CAA.
There are natural questions that come up. Why are you positioned so conservatively? Isn’t global economic growth accelerating? Aren’t corporate earnings healthy and beating expectations? While we would answer yes and certainly agree with those points, that’s just not the whole story.
As part of our investment process, we spend a lot of effort trying to better understand “what’s priced in” and weighing the fundamentals against what we’re willing to pay—valuation. We’ve all heard the expression that a great company can be a bad stock if you pay the wrong price; that same analogy can be applied to markets. With valuation levels having expanded along with the economic cycle, you’re already paying for an improving economic backdrop. As we look forward from these levels, return expectations need to come down to reflect this current market environment where we’re not being paid to take additional risks.
I would add that the Cambridge Asset Allocation Corporate Class portfolio has not always been positioned conservatively. In 2011–2013 the portfolio held a much higher exposure to equities, which at the time made some clients uncomfortable. This positioning paid off over the ensuing years, and our clients were rewarded for taking on the equity exposure when the opportunity was there and the expected risk-adjusted returns were skewed to the upside. That is not the case today.
Sentiment is leaning very bullish. A recent fund manager survey showed that a record high percentage of portfolio managers were taking higher-than-normal risks in their portfolios; equity allocations among hedge funds is at an 11-year high; a record high percentage of respondents stated equities are overvalued, yet average cash levels are falling (chasing the market higher!)—all while nearly half of respondents describe their investment horizon as three months or less. This market has a FOMO—“fear of missing out”—which we’ve heard strategists talk about as a reason to join in. Volatility has also been very low, soothing market participants into a false sense of security. Broad equity market volatility as measured by the VIX Index is close to all-time lows, the MOVE Index (a measure of treasury market volatility) is at all-time lows, while the CVIX Index (a measure of currency volatility) is sitting at multi-year lows. With an abundance of liquidity, credit spreads have tightened and are near all-time lows. For an example of how spreads have compressed, look at how Greece’s 10-year government debt is trading. Greek bonds are changing hands at tighter than a 300 bps spread to 10-year treasuries—compared to over 1000 bps in 2015 or 2500 bps in 2012. The market’s perception of risk has certainly changed.
When nearly every meeting turns to the merits of Bitcoin, or marijuana stocks, or artificial intelligence, or self-driving cars, we certainly get the sense there’s a speculative element to this market. Nearly everything is going right and expectations are that this environment will continue—in many cases, the good news is priced in.
Although we are not happy with lagging this year, we will continue to abide by our investment process and stay disciplined to the same philosophy that has delivered strong risk-adjusted results for our clients over the long term. When we put your hard-earned dollars to work, we will remain focused on the potential reward as well as the potential risks, even when the market isn’t. We are invested alongside our clients and will do what we think is right to protect and compound wealth over the long term.
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