Portfolio Predicament

In 1952, Dr. Harry Markowitz received a Nobel prize for an essay outlining the tenets of ‘Modern Portfolio Theory’. In very simple terms, Markowitz’ theory posits that an investor can reduce the overall volatility of his portfolio by diversifying his investments among a group of non- correlating asset classes. In other words, when one asset class – stocks, for example – goes down, a savvy investor’s diversification into bonds and real estate will help hold the value of his portfolio steady.

At this year’s Global Alternative Investment Management (GAIM) conference, Harry Markowitz impressed two critical insights upon me…and an important conclusion.

The first insight came during Markowitz’ presentation. Reprising a speech he gave last year on the 50th anniversary of the publication of his paper, Markowitz went through the history of how Modern Portfolio Theory came to be. Buried in a slide discussing the non-correlation between asset classes was the point that in the 1980’s, the world assumed there was no correlation between the U.S. and international stock markets. International stock markets were considered a separate asset class and were marketed as such.

Harry Markowitz: Diversification “Protection”

Today, we know that the correlation between the “U.S.” and “international” stock market classes is quite high. The diversification “protection” an investor got from investing offshore in 1980 has disappeared, as world markets have all tanked at the same time in the past few years. Markowitz’s point was that if you attempt to diversify, it is important that the markets you diversify into don’t actually move together.

This same oversight caused the spectacular failure of Long Term Capital Management in 1998. That fund, led by Nobel prize-winning economists, profited for years by making a highly leveraged bet that the interest rates on bonds would converge. In 99 out of 100 years, that is the case. They believed they were diversified because they held bonds in scores of different nations. Their theory was that even if the 100-year flood happened in Norway, if you only had a small amount of your capital in Norway, you were protected.

What they discovered too late was that in times of stress, the world had become so connected that there was no benefit to diversifying among countries. LTCM went down in flames, drowning in the flood in Norway and the rest of the world.

Markowitz, in his work, allowed for correlations to change over time. When Wall Street uses his theory, it does not; it does not want to be involved in “market timing”. Instead, analysts tell their clients to use such-and-such a fixed correlation portfolio, and that over time, things will even out. They wait for their correlation studies to become fatally flawed, and then change them after the fact. By then, customers have lost their shirts.

Harry Markowitz: A Demonstrably False Premise

In a GAIM keynote luncheon address last year, I argued that Modern Portfolio Theory has been misused by Wall Street to persuade retail investors and large institutions alike to remain in poorly performing assets. The argument that you must always stay invested in stocks because they always go up in the long run is a demonstrably false premise. It is one of those economic arguments that work fine in theory, but in practice, are a prescription for disaster for investors.

When I took the opportunity to ask Markowitz about his views on how Wall Street has used (or misused) his theory, the second insight presented itself. In the lobby of the PGA National Resort, there was more than one eye raised as the charming elder statesman and educator, deprived of his chalkboard, enthusiastically began to draw graphs in the air to illustrate his answers. He was kind enough to draw the graphs backwards, so that they could be “viewed” correctly from my position. I would have loved to have sat in his class in college.

At first, Markowitz replied that he thought Wall Street had done a reasonable job in helping institutions to diversify. At some point, however, I brought up the point that Wall Street has used his work to justify ‘buy and hold’ policies, which were not helping small investors.

“Aahh,” he replied. “It all depends upon which assumptions about future returns you use.”

And therein lies the rub. Wall Street and mutual funds use various studies to show rather large returns for the stock market. Stay fully invested, they say, and you can eventually grow rich. Many pension funds assume 9% to 10% returns on their total investment portfolios. Since 30% or more of their funds are in bonds, this means they assume they will be getting at least 12% or more each year from stocks.

As the saying goes, there are lies, damned lies and statistics. Using past performance as a guide, what your return over the next decade will be all depends upon when you start and when you end your study. Using a 70-year study to predict future returns, as Yale’s Roger Ibbotson has done, is worthless, as none of us will ever invest in an index fund for 70 years. Further, it is misleading to suggest such a statistical relationship between a 70-year period and any given 10-year future period.

Harry Markowitz: Apples to Apples

But even comparing ‘apples to apples’ has its problems. For example, take any two dates for the Dow, 20 or more years apart, from the last 100 years, on which the Dow P/E ratios are similar – and then look at the annual returns. The results show numbers that are all over the board, and nothing ever approaches 10%. If you start in 1908, when P/E ratios are 12.5, and then go to 1986, when P/E ratios are 12.38, the returns over that period average about 4.75%. Multi-decade periods within that time, but with the same P/E ratio at the beginning and end of the period, produce a range of returns from 5.5% to 3.29%.

As you look at the data, the overwhelming fact that jumps out is that the most important single factor that determines your future investment returns is the point from which you start calculating. If you start during a period when P/E ratios are dropping (secular bear markets), your return for at least the next decade is going to be flat at best. If you start when P/E ratios are rising, your returns are going to be very good. They can very well be in the 10% plus range for long periods of time.

Sadly, we are now in a period of where P/E ratios are going to go down. This is a process that will take many years to finally complete. That means investors cannot use the investment strategies which worked during the last two decades. They cannot use relative-return ‘buy and hold’ index funds, or even most stock mutual funds, and expect to make progress. Instead, they must seek absolute return investments.

What does this mean? Well, it implies that your investment portfolios are going to grow slower than most of you would like. The era of 12-15% is over. Done. Gone. To try and grow them faster implies you will be taking more risk. But this is a perilous decade for risk-taking. Rather, it is a decade for risk avoidance.


John Mauldin,
for the Daily Reckoning
February 10, 2003


It’s another gloomy winter day here in the Daily Reckoning Paris HQ, not least of all as your editors are elsewhere.

Bill is on a plane bound for Nicaragua…and Addison is snow-bound in New Hampshire. But our faithful man-on-the- scene in Manhattan, Eric Fry, is here with the latest news from Wall Street for you…



Eric Fry, reporting from New York:

– The “sandpaper” bear market keeps grinding away. 189 Dow points turned to sawdust last week, as the blue chips dropped to 7,864 – the index’s lowest level since early October. The Nasdaq fell 3% to 1,282.

– “The poor start to the year might be a harbinger,” USA Today points out. “Of the 19 times since 1950 when the market fell in January, stocks finished up for the year only seven times, the Stock Trader’s Almanac says.”

– We shudder to think what a losing January AND a losing February might portend…A fourth straight losing year perhaps? Of course, Mr. Market does not observe the Gregorian calendar…or any other calendar, for that matter. He observes only the seasons of investor emotions, and now is the winter of their discontent…or at least the late autumn.

– “Wall Street today is in one of its recurrent sinking spells,” writes James Grant, editor of Grant’s Interest Rate Observer. “Many call it a crisis of confidence, by which they mean under-confidence. Less attention is given to the preceding crisis of overconfidence…Markets are cyclical. First, investors trust too much. They believe that no price is too high to pay for a stock or a bond, then they doubt that any price is too low. So credulity is followed by cynicism, unreasonably high prices by ridiculously low ones.”

– To be sure, stock prices are no longer “unreasonably high,” but neither have they become “ridiculously low”. At least, not as most might define “ridiculous” – the sort of valuations that typified the stock market in 1982, when stocks sold for eight times earnings and yielded 6%…Now, THAT was ridiculous!

– The seasonality of investor sentiment manifests itself in all financial markets, commodities as well as stocks. Prior to 2001, two decades of falling commodity values had driven the price of most commodities to ridiculously low levels, in many cases below the cost of production. Even today, after a two-year rally, commodity prices are still low.

– Curiously, despite the rallying commodity markets, long- term bond yields remain below 4%. Normally, bond yields rise when commodities are rallying. One of these two markets would appear to have it wrong.

– “The deflationists own Treasurys,” Jim Grant observed recently, “while the inflationists own oil, gold, nickel, natural gas, soybeans etc. For now, everybody – temporarily – is happy. The question before the house is which constituency is more likely to become unhappy?”

– Bridgewater Associates – like the New York-based editor of the Daily Reckoning – unapologetically, albeit humbly, predicts that bonds will become less happy as time goes on. “Arguably, we are in the midst of the most powerful commodity move in the last 22 years, and this will now start hitting the CPI,” Bridgewater Associates asserts. “One of the major global themes in 2002 was the powerful surge in commodity prices. So far, 2003 has seen the move continue…[Therefore], our estimates suggest overall inflation will jump well above 3% in the coming months…Given the commodity move, this is pretty much baked in the cake.

– “Prices are rising across all major commodities,” Bridgewater continues. “96% of all major commodities are up since January 2002 [lean hogs being the one exception…But who would want a ‘lean’ hog anyway?].”

– Standout performers since January 2002 include coffee, which is up 130%, and propane and natural gas, which have more than doubled. But who cares about coffee or propane when gold and oil are capturing all the headlines? Gold and oil are the Taylor and Burton of the commodity markets – glamorous, volatile and prone to making front-page news.

– Last week, gold soared to nearly $390 an ounce before retreating to finish the week at $370. The energy complex put on an even more dramatic performance, as crude oil, heating oil and natural gas all soared to multi-year highs.

– Crude for March delivery rallied nearly $2.00 to $35.12 a barrel, its highest level since November 2000. Next up, natural gas jumped 8% to $6.043 per million BTUs. Not to be outdone, heating oil gushed an incredible 17% last week, from 93.2 cents a gallon to $1.10…Time to shut off the furnace and start foraging for firewood.

– Commodity bulls may be enjoying the rallying energy markets, but the rising cost of driving a car and heating a home will bring no smiles to the faces of consumers.