In last week’s update I mentioned that within our own shop we often have disagreements about the economy and markets. Based on my email flow, that seems to have surprised and possibly confused some people. So, I want to spend some time this week talking about investing more generally rather than concentrating on the week to week data flow and trading activity. Markets generally continued their previous trajectories last week anyway despite continued geopolitical tensions and the continued flow of mixed economic data.

Investing can basically be broken down between two disciplines: active and passive (art and science). I don’t think most people really understand the distinction, confusing the use of an index fund with passive investing and the use of individual securities with the active version. Let’s look at the passive (scientific) approach first.

The mere use of an index fund does not in itself constitute passive investing. Indexing is only part of the process and really not that important to the implementation of a passive approach. Passive investing is not about the investment vehicles used but rather about asset allocation, the process of dividing your funds among various types of assets: stocks, bonds, commodities, real estate, cash, etc. While the most pure form of passive investing would have you use index funds for each of those asset classes, that isn’t the important part of the equation. Academic research indicates that over 90% of the variance in returns among portfolios is from asset allocation, not security selection or market timing.

Passive investing can take many forms and there is probably as much disagreement among passive investors as there is between the passive and active crowd. Should commodities be part of the portfolio? What role should cash play? Should capitalization weighted indexes be used or price weighted or equal weighted? What should the breakdown be between these various asset classes? But ultimately, passive investing is about creating an asset allocation of, preferably, low correlation assets and rebalancing the portfolio periodically. At Alhambra we have a number of versions of passive portfolios with as few as 5 assets and as many as 13. And I could point you to almost endless variations available from smart people from all over the industry.

Passive investing is the market expression of the efficient markets hypothesis and history says it works over long periods of time, assuming you pick a plan and stick to it. Constructing a passive portfolio is merely a matter of math; using correlations, historical returns and volatilities, one can produce a portfolio that will perform well in the future assuming that it at least resembles the past. But the key part of becoming a successful passive investor is the last part of the first sentence of this paragraph – sticking to it. And that is where an adviser, as opposed to an algorithm, can be very helpful. It can be very difficult to stick to a passive plan when all hell is breaking loose a la 2008. An adviser is there to remind you why you chose a passive approach, hold your hand and make sure you don’t abandon it at the most inopportune time. And that is very valuable indeed. Passive investors who ignored the news and just stuck to their plan in 2008 ultimately made out fine. The drop in stocks and the rise in bonds forced them to buy the former while selling the latter. In other words, it forced them to do what everyone says we should do: buy low and sell high.

Active investing, contrary to the passive approach, changes the asset allocation based on current conditions and expectations. That active approach may involve the use of index funds but that does not make it a passive portfolio. Active investing, as I said above, is the art of investing. Active investors take into account valuations, economic outlook and a variety of other factors when determining asset allocation. It is a forward looking approach rather than the backward looking approach of the passive investor. Some might say that active investing depends on the ability of the practitioner to predict the future but I don’t see it that way. If anything it is only a more nuanced and detailed way to view the past.

Let’s look at one example today: stock market valuations. Those who see the current market as fairly or even cheaply priced are ignoring the parts of history that interfere with their desire – greed – to be invested in a market that is rising. There are a lot of different ways to calculate stock market valuation but the ones that have provided useful information about future returns are routinely ignored by today’s bulls. The fact is that valuations look cheap today because profit margins are near their all time highs. If we assume that those margins will revert to their long term mean (even one that has been rising the last few decades), valuations don’t look nearly as cheap. Active investors with a sense of history are not trying to predict the future; they are merely pointing out the risks to the bullish view and assuming that history with respect to margins will repeat.

And that is where tracking the economy comes into play for the active investor and where many of our internal disagreements come about. Margins contract in recession and expand during growth phases so anticipating a recession or recovery is paramount to successful active investing. We take two views of the economy, one focused on the very long term and one focused on the near term. We have little doubt that our long term view of the structural problems with our economy will be proven true over time. The US economy – and the global economy for that matter – faces two big headwinds to future growth; work force growth and productivity growth. We have an aging population, a contracting work force, that will act as a headwind to growth just as it has in Japan over the last three decades. Productivity will be the fulcrum of future growth and the reduced levels of investment over the last two decades do not bode well for those who believe we will soon return to our historical rates of growth. There are a lot of factors tied up in that simplified analysis – much of it do with monetary policy and high levels of debt – but we are confident that without a dramatic change in economic policies, the US faces, at best, a long period of low growth. And recessions have not been repealed so there will be periods of contraction.

The shorter term is much harder to predict, subject to interpretation and probably skewed by our own longer term negative bias. Over the shorter term, which can encompass several years, there are factors which affect markets that have nothing to do with our long term problems. Activist monetary policy has the effect of distorting prices and in the short term those price distortions can lead to economic changes that are measured as growth but in the long run are likely to prove to be what Austrians call malinvestment. As I’ve said many times in our internal discussion, in the short term malinvestment is indistinguishable from investment. Just to take one example today (and there are plenty), we believe that the current mania for investment in oil and gas exploration, particularly in the shale plays, is likely to prove a large waste of resources in the long run. In the short run though, the shale investment has proven a boon to certain parts of the country and the economy. I would venture to say that absent the (mal)investment in shale over the last 5 years, the US economy would have long ago entered another recession.

From an investment perspective, what we are faced with now is a disagreement between our long term views and what we see as somewhat improved economic conditions in the short term. Even if we assume the economic data continues to improve, deciding how that will affect markets is difficult at best. Will traders assume that better economic data will push forward the Fed’s tightening schedule and sell? Or will they see the better data is a boost to earnings and even better growth and buy? What effect would a stock market correction (or junk bonds or leveraged loans) have on the economy itself? Could a correction actually cause a recession? What will the end of QE bring? The last two times QE ended stocks sold off but was that due to the end of QE or other factors? What effect will the renewed recession in Europe have on not just US and European stocks but Asia and other areas of the world that depend on exports? With all those questions, it shouldn’t be surprising that we sometimes disagree about the direction of markets. We are nothing more than a microcosm of the market as a whole.

There are no formulas for active investing; it is much more art than science. Sometimes we paint beautiful pictures and sometimes we get finger painting. That’s one reason we practice both types of investing, passive and active. Most investors would be well served by doing the same, having a portion of their assets in a purely passive portfolio while taking a more active approach with the rest. The active share of the overall portfolio is itself an asset allocation choice. The more you have in the active portion the more your results will reflect your abilities at active management. The less you have, the smaller the impact on the overall portfolio.

Investing is not an all or none decision. There is nothing wrong with choosing both the art and science of investing, active and passive. Disagreements about the active portion are par for the course and debate is healthy. I’d be a lot more worried about our internal processes if we all agreed.

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“Wealth preservation and accumulation through thoughtful investing.”

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.