The Globe and Mail, Report on Business
Published November 12, 2010
By Tom Bradley
It’s only been 18 months since the nadir of our once-in-a-lifetime financial crisis, but it feels like we’re already forgetting some of the lessons learned. I’m referring to the fact that, in this market full of cross currents, we have another major asset class getting frothy and investors making bigger bets in their portfolios than ever.
Inflating the gold bubble
We’re still talking about how ridiculous it was that so few people saw the housing bubble coming, or the tech wreck for that matter. But are we doing it again with gold?
Certainly we can tick off a number of boxes on the bubble checklist. The shiny metal has been on a 10-year rocket ride and there are authoritative voices predicting even higher prices ahead (check). Nobody is calling for a pullback, at least not publicly (check). It’s not like 1979-80 when people were lining up on the street to buy bullion. Now they’re queuing at their investment dealers and Bay and Wall Street firms are responding with a rash of new gold-related products to meet the demand (check). Precious metals funds will end up being some of the largest IPOs of 2010 (check).
But the scariest feature of this cycle, in my view, is that investor purchases now make up approximately 40 per cent of the demand for physical gold (check, check, check). This percentage is up from a token amount 10 years ago when gold started its move from $250 (U.S.). If the speculators stop buying, let alone start selling, there’s a lot of downside in the price. As Sir John Templeton once noted: “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” Like the tech stocks that traded at huge valuations at their euphoric peak, gold and gold stocks will have a lot of air under them when the cycle ends.
Market timing gone mad
I don’t have hard evidence, but it appears that investors are making bigger market timing bets than ever before. There are two aspects to this that are noteworthy, but not totally consistent. The first is that many investors are keeping large amounts of cash on the sidelines due to concerns about the economic outlook. They’ve sold stocks, or delayed making new purchases, such that their portfolios are nowhere near their long-term asset mix. In other words, they are making a big bet against the stock market.
The emergence of specialized exchange-traded funds has also encouraged more market timing and sector rotation. ETFs were once billed as a low-cost way to invest for the long term, but the reality is they’ve become market timing machines. The advertisements tell us that we can click a button and make a bet on the oil sands one day, shift over to natural gas the next, and finish the week owning gold.
These quite different bets – the cash build-up and active sector rotation – both imply that investors are more confident in their ability to time the market, but that’s not the case. It’s more likely that a decade of poor returns, a lack of trust in the old way of doing things and some effective marketing are what’s causing it.
Risk control 2.0
In face of these issues, I have a risk management tool for investors to consider. I suggest it with great trepidation because the risk management industry has fallen into disrepute in the last few years. It turns out that the statistical models, despite their brainy elegance, didn’t work when we needed them. Mine, on the other hand, is simple, reliable and easy to remember.
You just need to calculate what percentage of your purchases are going into securities that have done well in the recent past. You should also assess your overall portfolio on this basis. If all the money is flowing into the high fliers of last year – in today’s terms that means gold, high yield bonds, Canadian resource stocks and emerging markets – then an alarm will sound. It’s signalling that you’re investing while looking solely through the rear view mirror.
To keep the model’s alarm from going off, there needs to be a better balance between what’s been working and what’s most likely to work in the years ahead. As David Swensen, the chief investment officer of Yale University so eloquently put it, “Overweighting assets that produced strong past performance and underweighting assets that produced weak past performance provides a poor recipe for pleasing prospective results.”