I thought you might be interested in some thoughts about the investment climate around the time of the “great recession”. You may find them disturbing, or enlightening, depending on where you think we are today. But two things are fairly certain… not a whole lot has changed, and a look to the past often provides insight about the present.
- Without too much of a stretch, it could be documented that the stock market “Crash of ’87” was caused by investor focus on company fundamentals, as the best companies on earth led the market on a reckless course to a sudden and painful reversal of fortune for most investors.
- It would be a “piece of cake” to prove that the “irrational exuberance” of the “.com bubble”, ten years or so later, was caused by blind faith worship of technical analysis, as the “no value at all sector” flourished while profitable, high quality, dividend payers significantly underperformed NASDAQ’s much more speculative issues.
- More recently, blame for “The Great Recession” could well have been laid at the feet of big government, misguided regulators, and Modern Portfolio Theory zealots instead of heaped upon Wall Street banking institutions, complicit as they were in shaping the disaster. There was plenty of guilt to pass around.
In an April, 2010 post in Jotwell: Trusts and Estates: “Time to Rethink Prudent Investor Laws?”, Jeffrey Cooper paraphrases a similarly titled article by Stewart Sterk.
- Sterk, in my opinion, supports the assertion that Modern Portfolio Theory (MPT) and its computer creation “The Efficient Capital Market Hypothesis” were directly, without reasonable doubt, the cause of the recent global financial crisis.
By removing the “prudence” from the Prudent Man Rule, the federal government had allowed hypothesis and theory to replace profits and regular recurring interest payments. Effectively, probabilities, standard deviations, and correlation coefficients replaced fundamental value analytics, real profit numbers, and income generation capabilities, as determinants of investment acceptability in trusteed portfolios.
The Uniform Prudent Investor Act (UPIA), which reflects an MPT and “total return” approach to the exercise of fiduciary investment discretion, was adopted by most states by May 2004. The act stated that:
- No category or type of investment is inherently imprudent. Thus, junior lien loans, limited partnerships, derivatives, futures, options, commodities, and similar investment vehicles, were acceptable.
At the same time, Congress was: encouraging lenders to make mortgages available to absolutely everyone; allowing federal mortgage providers to package products for Wall Street; preventing the SEC from regulating a burgeoning derivatives industry; and making all regulators stay clear of any involvement with a growing interest in “credit default swap” gambling.
It’s not difficult to surmise just how involved Wall Street lobbyists were in making the once “sacred ground” of trusteed investment and pension plans a trillion dollar market place for every conceivable manner of “Masters of the Universe” creation/speculation. My assessment is that we remain in an “artificial portfolio” bubble as this is being written.
Not even Dodd Frank contained a solution to the problems that fostered the recession/ correction (at least not effectively). Both pension and defined contribution plan (401k) trustees are still expected to focus on portfolio market value growth instead of growing the income that plan participants will need at retirement… conservative, income based, portfolios would be fined mercilessly by feckless regulators for “poor performance”.
- The most popular “retirement income fund” on the planet (Vanguard’s VTINX) generates less than 2% in spending money, check it out… while hundreds of other securities, safely yielding much more, are unacceptable to the regulators.
Without a meaningful correction for over ten years, it seems likely that millions of investors are about to become victims of a “How Could This Be Happening, Again” debacle.
Blinded By The Math
MPT doesn’t just ignore all fundamental analytics while playing Frankenstein with the technical variety, it also pays no attention to the reality of market, interest rate, and economic cycles. It has produced an investment environment that has taken diversification to new heights of lunacy by including every possible speculation in the formula, while ignoring fundamental quality and income generation.
The only significant “risk”, it postulates, is “market risk”… in reality just the always clear and present danger of all securities and markets. The MPT mixologists’ concoction:
- combine all market price numbers of all securities irrespective of quality rankings, income, or even profitability numbers
- determine how these numbers varied against one another during various past market scenarios… regardless of cyclical cause
- measure the dispersion of the results as they relate to the average and latest iterations of the actual numbers (what!)
- measure the probability of each possible result, assign a “standard deviation” market value change risk measurement to each possible result, and finish by correlating the various risk assessments.
Add a shot of single malt, and a pinch of Old Bay, bring to a boil, shake a stick over it and SHAZAAM… we know the combined market, liquidity, concentration, credit, inflation, financial, and economic risk of every marketable security.
MPT portfolio construction assures that everything owned is negative directionally correlated to nearly everything else, without ever owning an individual stock or bond, or considering the amount of income produced by the portfolio. Thus creating, eh, producing, a passively managed… well, I haven’t quite determined what such a portfolio would be.
The “oxymoronic” passive management (let the formulas and standard deviations steer your retirement bound ship) of “Modern Portfolio Theory” may initially have a sexy ring to it… until you try to figure out exactly what it does to the data it fuels itself on.
Aren’t we bringing way too much science to a relatively simple system of exchanging dollars for ownership interests in business enterprises… an age old means for taking measured financial risk in the search for increased personal wealth.
MPT has spewed forth thousands of derivative products that have changed the equity playing field…
- Should an uptick in a “triple-short-the-S & P 500” ETF be considered a positive or a negative?
- Should individual issue numbers be adjusted for the number of derivative entities that hold them, short or long?
- Does share price have anything at all to do with fundamental value or is it just the impact of derivative parlor game activity?
S & P p/e ratios are roughly 50% higher than they were five years ago; a sampling of high-dividend-paying ETFs sports an average p/e more than twice that of the S & P… and none of your advisors (myself excluded) seems concerned with the anemic level of income being produced by your retirement-bound portfolios.
Déjà Vu all over again?
Modern Portfolio Theory would have us believe that the future is, indeed, predictable within a reasonable degree of error. Theorists, research economists, other academics, and Wall Street marketing departments have always gone there — and they’ve always been wrong.
Any claim to precision; any attempt to time the market; any hope of being at the right place at the right time, most of the time, is just not a reality of investing. And there’s the rub for both forms of analysis, and for “the emperor’s new clothes” risk assessment techniques and “active asset allocation” processes so popular in MPT.
So long as we live in a world where there are tsunamis and Madoffs; politicians and terrorists; big corporate egos and far more dangerous big government; and imperfect intelligence (both human and artificial) there will be no hope of certainty.
Get over it, reality is pretty cool once you’ve learned to deal with it.