Navigating Market Storms

Like most new companies, Alhambra started as a small operation. In its early days, Alhambra Investments was just me and one employee – Marcelo Perez, who is still with the company – managing a modest sum for retail investors. The office was most often my pool deck, working under Florida’s blue skies. The market still enjoyed blue skies too, back in 2006, but clouds were forming and the storm would first make landfall in July of 2007.

It was late in that month when markets started reacting to the subprime lending problems that would ultimately lead to the Great Financial Crisis of 2008. Much to my wife’s annoyance, I spent most of a San Francisco vacation in my hotel room tracking the market and trying to figure out what the heck was going on. Our client portfolios actually weathered those first few months of turbulence well; the Fortress approach was paying dividends for our clients. Stocks began to fall in late 2007, but bonds and commodities performed well, providing balance as they were supposed to do. Commodities roared higher in early 2008, and as a result, our client portfolios were up, while the typical stock-heavy portfolios others were holding fell.

That success was largely due to the construction of the Fortress Portfolio, aimed at performing well in all types of environments. But even then, I was actively making some tactical adjustments to client portfolios. However, small changes were not going to be enough to avoid losses in what was becoming a perfect storm of risks. Indeed, by the fall of 2008, our portfolios were also getting buffeted. Commodities were down almost 50% from their mid-year highs, stocks were down over 30% and the 10-year Treasury was just flat.

The 4th quarter of 2008, the most intense part of the crisis, was exhausting. My days started early – monitoring foreign markets to get an inkling of what to expect at the New York opening – and ended late. The portfolios were swinging wildly during market hours and I spent after-hours doing my best to keep clients calm. I dreaded seeing Treasury Secretary Hank Paulson’s face on TV because I knew it meant more bad news or another change to the rapidly multiplying bailout programs, the implications of which were impossible to divine. We had a term for situations like this in the Navy but it isn’t one I can use in polite company.


Aftermath of the Storm

By 2009 the storm finally began to recede, and investors assessed the damage. The S&P 500 was off its lows, but still down 37 percent from its highs. Some investors fared far worse. On the other hand, our moderate risk Fortress Portfolio was down less than half that of the S&P 500. More conservative portfolios fared even better. Our clients, for the most part, were appreciative of the results, especially after they had a chance to talk to friends, many of whom weren’t so fortunate.

Many money managers shrugged off 2008 as a once in a lifetime, freak event and tried to forget about it. I went the opposite direction and began to study the experience for lessons, with an almost obsessive focus. I had come through the 2000 bear market nearly unscathed by avoiding technology stocks. Alhambra and its clients had survived the crisis of 2008 but the ad hoc tactical changes I made to the Fortress that year were obviously not sufficient. Some of the changes were helpful, others were not. In the end, I probably would have been better off with a strictly passive Fortress Portfolio. A purely passive approach is the best choice for some portion of your assets. Merely finding a strategic plan you can stick to and capturing the passive return is an accomplishment in and of itself. But I also became convinced that an active, tactical approach could add value if implemented within strict protocols.

I needed new active investment processes and more bandwidth than a staff of two to build them. It turned out the answer to both my problems would be found around research. I had just become an editor at Real Clear Markets, and other investment thinkers were now submitting their research and analysis to me for publication. One that stood out was Jeff Snider. He showcased a deep understanding of the systemic risk environment and workings of the capital markets. Jeff’s clients had actually made money in 2008 based on his analysis. I soon recruited him as one of my first new additions to the team. Others would follow, as I increased our intellectual firepower.


Navigation Tools

I began to build the framework of a new active investing process on the foundation of the passive process of our Fortress Portfolio. We still recognized four distinct investment environments: Growth Rising, Dollar Falling; Growth Rising, Dollar Rising; Growth Falling, Dollar Falling; and Growth Falling, Dollar Rising. We also still recognized that some investments do better than others in those particular environments. Now, we researched the question of how could we actively navigate or transition our investments from one to another to capture more gains and avoid losses.

How could we predict a Falling Growth, Falling Dollar environment, for example, and move to favor commodities over stocks? Jeff had already joined the team to lead our analysis of high-frequency economic data, as well as systemic risks of the type that had hammered markets in 2008. Along with his research, our investigation identified five other tools to leverage in actively managing investments. When making changes to investments we focus on:

  • Yield Curve – the difference between long and short-term rates is the most accurate predictor of recession and recovery
  • Credit Spreads – the difference between junk bonds and Treasuries is another good indicator for recession
  • Valuation – valuation provides a good estimate of future returns and therefore risk
  • Momentum – momentum exists in markets because humans trade on emotion
  • US Dollar – the movement of the dollar can have a dramatic impact on various asset classes

If the yield curve and credit spreads indicate an economic recession is imminent we can shift away from risk assets, like stocks, and into safer assets, like bonds. If stock valuations are low, we can shift to overweight stocks. If momentum is strong for real estate, we can increase exposure. If the U.S. dollar is trending lower, we can buy more commodities and foreign investments. The value of using the yield curve, credit spreads, valuation, momentum and the U.S. dollar are all well documented. Yet, how we began employing these tools to navigate within our paradigm of four distinct investment environments was unique.

In the wake of the 2008 market storm, a more ambitious Alhambra Investments was emerging. Research not only remained at the heart of the company but became an even greater strength. In fact, our analysis of the types of systemic problems that caused the Great Financial Crisis became a strength to the point where other industry professionals began following our analysis, in order to better understand market risks. However, our focus wasn’t on educating our competitors. We concentrated our work around building and managing new active investment processes.

Alhambra’s days of being a two-man shop by the pool were over. There was now a team of us diligently focused on research, working on new portfolio processes and managing money for new clients. This market storm had passed. But I knew it was only a matter of time until another arrived. I was determined that before it did our clients would have some powerful actively-managed portfolio strategies to grow and protect their wealth.