Thinking Strategically in a Short-Term World

There's more than a week to go before the Fed's next scheduled FOMC meeting on March 18, but judging by the February employment report that was released on Friday morning the odds of another rate cut look virtually assured.

On Friday, the Labor Department reported that payroll employment slumped by 63,000 last month. That's the second monthly decline and the steepest in nearly five years. Perhaps the economy's capacity for minting new jobs is set to rebound, but it doesn't look that way. As our chart below suggests, cyclical downturns have been known to run for a while, suggesting that at this moment it's premature to think that the economy has now purged itself of excess.

Yes, the previous downturn was extraordinary in some ways and so perhaps the recent past isn't necessarily prologue this time around. The hope is that the current slump will be short and mild, but as always there's no guarantee. In fact, there are more than a few reasons to think that we may be in store for something more than a brief rough patch. For example, mortgage foreclosures jumped to an all-time high at last year's close, the Mortgage Bankers Association reported Thursday. Meanwhile, home equity dropped under 50% for the first time since World War II in last year's fourth quarter, according to the Federal Reserve.

Making a case that the economy's under stress is, in short, rather easy these days. The data certainly suggest as much, and so it's no wonder that the market's expecting another cut in Fed funds rate. The May '08 Fed funds futures contract, for instance, is priced for a 2.0% Fed funds rate - 100-basis points below the current level.

The stock market is obviously sensitive to the news of late, as is the bond market. Predictably, each is going their separate way. The S&P 500's total return this year through Thursday's close was in the red by -10.8%, according to Morningstar.com. The Intermediate U.S. Government Bond Index, by comparison, was higher by 4.4%. The flight to safety is very much in force, and so valuations and long-term return expectations are being ignored in the stampede. These dual trends won't last forever, but there's still plenty of fuel to keep the game going - for now.

This is par for the course in corrections. They eventually die when the sellers are exhausted, and the Fed has done all it can reasonably do to resuscitate the patient. By our reckoning, we're still shy of the halfway point in this process, although that's only a guess and one that probably suffers from a wide margin of error.

Perhaps the bigger danger is that as the correction process continues, investors will find themselves drawing the wrong conclusion from the recent trend. The bias was on full display when everything was running higher, and now it threatens to work in reverse when several major asset classes are tumbling, notably, stocks and REITs. Alas, we can't predict the bottom, but we know that lower prices equate with higher expected returns. For those with a five-year time horizon or longer, the rebalancing opportunities are getting better by the day. In fact, 2008 is shaping up to offer the best prospects for strategic-minded investors since 2002.

As always, Mr. Market gives nothing away. Yes, expected returns for some asset classes are rising. But at what cost? Surely the free lunch doesn't exist. Indeed it doesn't. Rather, the price tag is living with a hefty dose of anxiety for the foreseeable future. Buying when virtually everybody else is selling is about as comfortable as walking on nails. But that's the price for improving the odds that your portfolio's risk-adjusted performance doesn't suffer mediocrity in the long run. As our second chart below reminds, return series are volatile, even over rolling 3-year periods, which is what we illustrate below.

Yes, it's obvious what we should have done in the past. There is no doubt that we will make mistakes in real time about second-guessing the future. But a large chunk of the prediction risk can be mitigated by owning all the major asset classes and adjusting the weights when the valuations, volatilities, and other metrics signal that it's a prudent time to act. Additional risk reduction can be had by time diversification. Rather than trying to pick a single point of maximum expected return (i.e., market bottoms), investors are better off deploying new capital over a time period that's reasonably close to the bottom. In short, plan on being a bit early, and a bit late relative to the absolute bottom when attempting to exploit volatility. Why? It's a tool that improves the odds of capturing the lion's share of the opportunity.

click to enlarge

Uncomfortable? Absolutely, but far better when you consider the alternative. Trading short-term comfort for superior odds of long-term success still looks like a winning bet. Even so, no one said it'd be easy.

• Investing for Retirement - Cramer's Mad Money (7/3/08)  »
• Independence Day Memories of a Stronger Dollar, Lower Costs  »
• What Was Left Out of the Jobs Report  »
• Commodity Driven Role Reversal  »
• Does Valuation Matter?  »

This article has 1 comment:

• iThinkBig

  Mar 09 11:42 PM

  My Website
  I'll wait to invest, thank you. Let's see how the election is shaping up in November. Meanwhile, cash is becoming scarce and general contraction will continue to occur, at least for the foreseeable future.

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