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The Disconnect Between Theory and Practice

First Quarter 2012

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In this quarter’s perspective, we relate both historical and current economic principles with investment portfolio construction. Our conclusions can be summarized as follows:

Economics:
Investment Portfolio Construction:

With the Supreme Court taking up the matter of the constitutionality of the private mandate within the Health Care Act, thoughts drift back to another era and another landmark ruling by the High Court. As detailed by financial journalist Amity Shlaes in her 2007 book, The Forgotten Man, the 1935 case of Schechter Poultry versus the U.S. also hinged on the interpretation of the Commerce Clause.

The Fix Is In

The Schechters were butchers in New York City and ran afoul of President Franklin Roosevelt’s National Recovery Act. That Act mandated broad-based “codes of competition” including price setting and other rules and regulations. Its stated aim was to make the economy more “efficient” via increased government control of business practices and halt falling prices (deflation) within the economy.

Both the Schechter case and the current one before the Court are notable for their Constitutional implications to be sure. Both cases have large political elements as well. Our intent, however, is to examine their economic and investment aspects. Both cases involve a fundamental economic issue concerning the allocation mechanism for goods and services in the U.S. economy. Who should be doing the allocation—the visible hand of government or the invisible hand of millions of economic participants in commerce?

Ivy League vs. Main Street

The Schechter case provides some perspective through an interesting interplay between what are often termed “book smarts” and “street smarts” on the allocation issues involved. The government prosecution team was polished and Ivy League trained. The immigrant Schechters barely spoke English, had little formal schooling, and were represented by a modest legal team.

The Schechters were charged with, among other things, picking and choosing which particular chickens they wanted to purchase and determining prices for resale. Chastised for charging “low” prices, the prosecution repeatedly reminded the Schechters that they were not economists and, therefore, not qualified to set the prices of their products.

The Schechters’ defense was that competitive pressures determined prices within their industry. They also noted that while they were not economists, they were “economizers”. And economizer behavior of offering a good value proposition for their product enabled them to attract customers, fulfill customer needs, and earn a living in doing so.

NRA? No Way!

The Court ruled in favor of the economizer Schechters and the National Recovery Act was rendered unconstitutional.

The stock market advanced smartly after the 1935 Schechter victory

The stock market advanced smartly after the 1935 Schechter victory

Author Shlaes notes that many business people were very fearful of the increased power given to government within the National Recovery Act—and remember this was all occurring within a backdrop of ascendant central-planning communist and fascist governments around the globe. Shlaes points to the Act’s 1935 demise as a catalyst for a reduced fear of government intrusion and an important element in the substantial subsequent rise in the stock market (click the chart to the right for a larger view).


Consequences?

The economic elements in all this are worth pondering. First, note that a relatively fine line exists in the real world between making things better or worse when it comes to government intervention in the economy. Cross the line and the visible hand becomes the feared fist of government.

Effective regulation in the allocation of credit?

Effective regulation in the allocation of credit?

Knowledge about the allocation of goods and services within an economy is widely diffused. Millions of “economizer” decisions are made each day within the marketplace about what to provide, how much to charge, and what quantity to provide of any given item or service.

Furthermore, the marketplace for goods and services is mind-bogglingly dynamic. Through a trial and error process, businesses are constantly trying to gain a competitive edge by delivering new and improved goods and services. One time, powerhouses like Kodak, Blockbuster, and Borders that were earlier beneficiaries of the creative/destruction economic dynamism, now are at risk of being left irretrievably behind by new and more innovative value propositions.

When the government becomes involved in the allocation of goods and services, the benefits of diffused knowledge and marketplace dynamism are smothered. Absent these critical ingredients, the chances of government policy success on the economic front make the odds of winning the jackpot in the recent Mega-millions lottery look good. One would hope that solutions that harness the power of the marketplace be pursued.

A Framer’s Perspective

We will close this section with some additional perspective about the tension between a guiding hand and a demanding fist. The tension was anticipated way back in the forming of the nation. We reproduce a favorite quote of ours by former President James Madison, “Father of the Constitution”:

What is government itself but the greatest of all reflections on human nature? If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed: and in the next place oblige it to control itself.1

More on Street Smarts vs. Book Smarts

One trend over the past several decades has been the increasing application of mathematics within the world of economics and investments. Heavy duty “math” has brought many concepts and tools that have added insights and augmented knowledge within these fields.

But the “math” trend has not been all favorable. Increasingly rigorous mathematics has often introduced less than useful complexity. Equally troublesome, it has often shifted focus to what is quantifiable at the expense of what is really important within the financial world. For example, a student in economics today will probably learn that economic growth is a function of the amount and quality of land, labor, and capital (machines) available.

Other factors like innovation usually receive acknowledgement as somehow relevant in economic growth models. But because “idea” factors like innovation are hard to measure, their role is typically relegated to be of minor importance in economic growth theory. Yet history reveals that innovation is the driving wheel of economic growth. Over-emphasis on the more easily measurable world of “things” like land, labor, and capital often leaves economists repeating the Malthusian mistake.


Malthus was the 18th century English minister-turned-economist who predicted mass starvation as he confidently forecasted population growth would outstrip the growth in the food supply. What Malthus failed to account for in his economic model of doom was the explosion of innovation that led to huge gains in the productivity of farming.

The Sky Is Falling?

Underestimating human ingenuity is a common condition. So is underestimating the dynamism of our economy. Economic models that share these short-comings often provide predictions and policy recommendations that are way wide of the mark, as we suggested earlier.

Consider the words of financial commentator Morgan Housel :

Every decade for almost a century has brought fears that the world will soon run out of oil.
• In 1914, the US Bureau of Mines predicted American oil reserves would be depleted in 10 years.
• In 1939, the official production was 12 more years before the wells would run dry.
• In 1951, the Department of Interior warned that we only had 13 years left.
• In 1977, President Carter warned that the early 1980s would mark the point of no return, where oil prices could only go one way: up. 2

We could update this list with “peak oil” fears from just a couple of years back as well.

Reality Check

What’s actually transpired? An oil and natural gas revolution unfolding right in front of our eyes as the application of innovative drilling technology holds the potential of changing the energy dynamic in a major way.

Housel goes on to summarize the underappreciated aspects of dynamism within the energy industry:

Big oil has some of the most skillful engineers in the world. (As a result) demand can’t be extrapolated into the future. Price changes behavior.

Author Matt Ridley adds additional helpful context as well:

For 200 years, pessimists have had all the headlines—even though optimists have far more often been right. There is immense vested interest in pessimism. No charity ever raised money by saying things are getting better. No journalists ever got the front page writing a story about human disaster was now less likely. Pressure groups and their customers in media search even the most cheerful statistics for glimmers of doom. The world of things is often subject to diminishing returns. The world of ideas is not: The ever increasing exchange of ideas causes the ever increasing rate of innovation in the modern world. There isn’t even a theoretical possibility of exhausting our supply of ideas, discoveries, and inventions. 3

Interpretation?

We believe today’s widespread gloom about the future will prove much too extreme. Yes, economic and geopolitical problems exist. The world has rarely been trouble free. But never before in history has information been so readily accessible and easy to share by so many. This allows for cross pollination of ideas, the flow of information, and sharing of knowledge that enables the tapping of the never ending human ability. Certainly hard to measure, but most important and encouraging. Fertile ground for investing abounds.

Comments on Investment Portfolio Construction

Math and complexity have also invaded the investment world. This trend got rolling with the development of Modern Portfolio Theory (MPT). MPT has its roots way back in the 1950s, as scholars introduced statistical concepts to investment portfolio management.

Stripped to its essence, MPT adds quantification to the age old notion of diversification. It focuses on the concepts of covariance and correlation—or how prices of different investments behave relative to one another. MPT adds rigor to the idea that investments that behave differently can be added to a portfolio to increase diversification and reduce risk.

MPT does not stop there, however. It also theorizes that an “efficient frontier” exists in a world where there is a linear trade-off between risk and return. Portfolios constructed along this frontier are “optimal” in terms of risk reduction through diversification and expected return.

While MPT is over 50 years old, it’s just in the past few years that MPT-driven portfolio construction has really caught on with the masses. And it has caught on in a big way, now likely representing the “conventional wisdom” of portfolio construction.

All That Glitters…

How to blow up portfolio diversification: Have many eggs that act alike

How to blow up portfolio diversification: Have many eggs that act alike

The allure of MPT is great; for it implies that such a portfolio approach provides the elusive “free lunch” in terms of risk and return. Add lots of eggs (called asset classes) to a portfolio basket and it becomes (seemingly) highly diversified and less risky. And by adding exposure to “new” asset classes, the promise of high returns and the “optimal” portfolio appears within reach.

To this allure, mix in a popular how-to book, 4 cheerleading by Wall Street as it seeks to capture lucrative fees for creating gobs of new asset class “products”—global stocks and bonds of all flavors, shapes and sizes, currencies, commodities, hedge funds and even ways to “harvest” market volatility—and the trend towards MPT-driven portfolios is off and running.

And MPT application appeared to work its magic in the 2000s…for a while. However, the Panic of 2008 revealed a serious flaw between theory and its real world application in portfolios. It was this flaw, by the way, that prevented us from embracing the conventional wisdom for portfolio construction.

Truly Diversified?!

No risk reduction, as most “asset classes” did move together

No risk reduction, as most “asset classes” did move together

For diversification to be effective, assets within a portfolio must behave differently during times when markets are under duress. However, as the chart to the right suggests (click it for a larger view), most asset classes and investment “products”, as Wall Street likes to call them, behaved like an amplified version of the S&P 500 stock index during that period of stress.

This lack of effective risk reduction came as a nasty shock to many investors who thought they were protected with highly-diversified portfolios.

Theoretical Relativity

Nor is the protection-ruining high correlation likely a one-time condition. In an increasingly “flat world” with money racing around the globe, different economies and assets are becoming linked in a manner not previously experienced. Like economic models that fail to realistically capture the economy’s inherent dynamism, MPT-driven portfolios can fail to capture the dynamism in underlying asset correlations.

Not only has MPT-driven portfolio diversification proved lacking, but the free lunch promise of higher returns has likely also proved disappointing. Just as 2008 marked a significant change in the economic climate, the risk/reward profile of some important asset classes that now fill MPT-driven portfolios have also been altered—and not for the better as the chart to the right illustrates (click it for a larger view).

Like previous investment conventional wisdom —“Japan will own the 21st century economy” in the 1980s, the “new era economy” in the 1990s, and “real estate prices don’t decline” in the 2000s, conventional portfolio construction may prove financially hazardous to investors.

The bottom line on MPT-driven portfolios: even though it originated more than 50 years ago, for some reason it is still called modern portfolio theory. However, MPT is still called only a theory for a reason!

Blended Portfolios

Leonardo Da Vinci once said, “simplicity is the ultimate sophistication.” There is an effective alternative to MPT-driven portfolios that approaches Da Vinci’s sophistication.

A portfolio of high-quality growth stocks with a variety of market caps, including multi-national businesses that derive a significant portion of their revenues and earnings from global markets, blended with high-quality bonds managed in a manner designed to temper the risk of stock investing is relatively simple and effective.

The Cream Rises…

First, consider that there was an investment class that did emerge in the panic to deliver effective portfolio diversification. It was high-quality bonds. They have been at the cornerstone of our blended bond/stock portfolio approach for years for exactly that reason.

Diversification when it has been needed the most

Diversification when it has been needed the most

The chart to the left reflects the diversification history of high-quality bonds during periods of stock market duress (click it for a larger view). As it suggests, the highest quality bonds (Treasuries) historically delivered the best diversification properties during periods of stock market duress. This makes sense, for typically stock market duress occurs during periods of economic weakness that also can stress corporate credit worthiness (impacting corporate bonds). Again, for this reason, Treasuries have typically played a significant role in our bond strategy within blended bond/stock portfolios.

Second, as noted earlier, correlations—the degree to which prices of investments move together—can and do change. While the above chart reflects specific times when bonds are negatively correlated to stocks (bond prices up when stock prices down), it is also important to recognize that most of the time, stocks and bonds have, in fact, been positively correlated. A blended portfolio approach by its nature retains sufficient flexibility for dealing with changing correlations.

Finally, valuation changes triggered by market gyrations can significantly alter the risk and reward potential of both stocks and bonds. A blended portfolio’s constituent pieces can be altered to reflect market valuation conditions.

The current relationship between Fed policy, bond yields & bond prices

The current relationship between Fed policy, bond yields & bond prices

The current situation in the bond market is a case in point. The diversifying properties of high-quality bonds have been rediscovered by many investors since 2008. In typical “shooting where the duck was” fashion, large inflows into bonds has occurred ever since. Meanwhile, Federal Reserve policy has augmented this trend by depressing interest rates, the consequences of which are represented by the graphic to the right (click it for a larger view).

Perhaps Too Much Froth

The result is that at present, high-quality bonds remain fundamentally over-valued. A 10-year Treasury yielding 2% remains well below the pace of economic growth. This is an unusual relationship and unsustainable. One need not be a hyper-inflationist to foresee bond yields rising and bond prices falling as the over-valuation condition is remedied.

As this over-valuation condition is alleviated, normally “safe” bonds will be anything but safe. The bond component of blended portfolios can be adjusted accordingly until the risk/reward profile of high-quality bonds improves.

Comments on International Investing

It is no secret that emerging markets economies have outpaced growth in “developed” world economies the past few years. Most believe that this superior growth will translate into superior returns for emerging market stocks.

History suggests otherwise, however. Compiling data on market returns across countries, researchers Dimson, Marsh, and Staunton ranked countries by their pace of economic growth for the previous five years and then contrasted this with country stock market returns. They found that the slowest growing countries had returns equal to or above faster growing countries. 5

Market Inefficiencies?

How can this be? When pondering this subject awhile back, The Economist magazine offered the following:

One explanation is that investors pile into the stock markets of high-growth countries until they become over-valued. That herd like behavior makes the subsequent returns disappointing. Another possibility is that economic growth does not always get captured by the stock market. The fastest growing companies are often unquoted; in emerging markets many businesses are family owned or controlled by the state. Even when businesses are quoted, their growth may be financed by additional equity issuance that does not boost the returns of existing shareholders. 6

To this we would add that emerging market economies are experiencing surges in wage demands that follow economic advancement. Rising wages mean growth in consumer spending for goods but puts downward pressure on the profit margins of businesses domiciled there. In addition, we think it naive to believe that bubbles in economic good times are only a condition afflicting developed countries.

Real estate bubbles, capacity constraints, and labor shortages are increasingly common conditions in emerging market economies. A de-bubbling economy is never easy on a country, its currency value, or its domestic stock prices.

Our Take

We still believe that the way to invest in the opportunities created by global growth, while sidestepping the growing pain issues just described, is through multinational businesses.

As always, we remain focused on understanding the current trends in fundamentals because it gives us the best probability for success. And if you’re an active social media user, please consider sharing this topic with your acquaintances.


 
Sources

1 Madison, J. (1788). Federalist 51.
2 Housel, M. (2011). Everyone Believes It: Most Will Be Wrong.
3 Ridley, M. (2010). Rational Optimist.
4 Swenson, D. (2000). Pioneering Portfolio Management.
5 Dimson, E., Marsh, P., & Staunton, M. (2005). Economic Growth & Global Investment Returns. London School of Business.
6 Buttonwood. (2011. May 19). The missing link. The Economist. Retrieved from http://www.economist.com/node/18713528