By Tom Bradley

Hello,

I am a Steadyhand investor and enjoy reading the newsletter like notes emailed periodically.

Recently Tom sent one focusing on the need to be cautious right now because of the investment climate and made an argument for keeping a sizeable cash reserve. Presumably the cash reserve is to take advantage of any major corrections anticipated in the market.

Is 'being cautious' not tantamount to 'market timing'? If not, can the difference be explained? On one hand, one is given the advice to invest for the long term, stick with one's allocation strategy and don't try to time the markets. On the other hand, we are being told the market is uncertain so increase your cash and wait for the right moment to deploy it -- or try to time the market.

Thank you for your thoughts.

We recently received this thoughtful note, which hits directly on a tension we have at Steadyhand. As the investor noted, we believe that market timing is difficult and the best strategy is to stick to a long-term asset mix.

Where the tension comes in is that we also believe there are times when market fundamentals and valuations get completely out of whack. Indeed, markets moving outside of a reasonable valuation range, on the upside and downside, is a recurring, predictable occurrence. To be more specific, at these ‘extreme’ times, our 5-year return expectations (the time frame we prefer) will either be well above or below the long-term average (7-9% for stocks). How long these periods go on and to what extremes, however, is anything but predictable.

Marrying these two things together, it’s our advice to clients (which we follow in managing the Founders Fund) to stick to their long-term mix a majority of the time. There’s always plenty of noise swirling around (bad news gets first billing), but there’s no prize in trying to fine-tune the mix based on short-term movements in the market.

When we identify market extremes, however, we will act. We think we owe it to our clients to do so. We’ll try to be cautious when the extremes are on the high/euphoric side and aggressive when things are overdone on the downside.

Are we at one of those extremes right now? I believe we are. I would describe the fundamental backdrop as fragile. Central banks around the world are so concerned about the state of the economy they don’t feel they can increase interest rates above crisis levels. Meanwhile, debt continues to increase and the sensitivity to interest rates is like nothing I’ve seen in my 32 years in this business.

This fragility would be quite acceptable for an investor if valuations were low to compensate, but they’re quite the opposite.

Let’s start with bonds. Yields are near zero after adjusting for inflation (i.e. real yields). It’s hard to determine what a reasonable level should be (it’s ranged between negative and 6-7% over the last 20 years), but as the market normalizes I believe bond holders will require a 2-3% real yield, which is 2-3% above where we are today. If that were indeed to happen over the next 5 years, my projection of a 1-2% return for the overall bond market would prove to be optimistic (reminder: when yields rise, bond prices fall).

As for stocks, returns are also projected to be quite low based on earnings growth and current price-to-earnings multiples. I’m currently using 4-6% per year for the next five years.

Note: These projections are overall market returns and reflect the environment our managers will be operating in, not our fund returns.

As a result, on a risk-adjusted basis cash is now quite competitive with bonds and stocks. A 1-1.5% yield isn’t much, but compared to a volatile 1-2% for bonds and really volatile 4-6% for stocks, it looks more reasonable. Certainly there’s a short-term cost to holding cash, but the diversification benefit and importantly, the flexibility will be valuable when we have a market downturn, whenever that might be.

Market timing? I don’t think so. We are positioning the Founders Fund to reflect what we think 5-year returns will be, which is unusually low at the present time.

We’re doing everything we can to generate the best long-term client returns and are committed to ensuring that our advice (and the mix in the Founders Fund) always reflects what we’re doing with our own money.