While getting out of the markets can be easy—especially after a string of robust gains like those we have seen over the past two quarters—the decision to get back in can be psychologically more difficult, particularly if market sentiment has shifted meaningfully (for better or worse). Investors have a notoriously poor track record of pulling the trigger, hoping for the market to turn in their favor before re-entering a position. By seeking to avoid possible near-term losses of an uncertain magnitude, investors raise the likelihood that they will miss out on longer-term gains. Rather than trying to seasonally time the market, most investors would be better served by staying fully invested unless there are fundamental reasons to reduce stock exposures.

At this time, we do not see that to be the case. First-quarter corporate earnings have been strong, by many measures valuations reasonable , the Fed is maintaining an accommodative monetary policy, and economic growth is decent.

This is not to say we anticipate stocks to go straight up throughout the summer. Volatility is likely, as investors weigh the ongoing debt crisis in Europe, the slowdown in China, the strength of the U.S. economy, and the resolution (or not) of the “fiscal cliff”. But looking out longer term, stocks currently look relatively well-positioned, especially compared to alternatives such as cash and bonds.

To read the full Market Pulse Report click here

So is it time to purge hedge funds from client portfolios? We think not.

The structural issues that can hamper hedge funds, such as limited transparency and/or liquidity, are not new, nor are the higher levels of fees. Hedge funds have been successful for decades despite these constraints. The argument against certain hedge fund strategies essentially boils down to the past three years of sub-par relative performance.

It is important to note a couple of things.

1) First, hedge funds come in many shapes and sizes, deploying diverse strategies with varying risk/return objectives. It appears to us that the heaviest criticism has been mounted toward funds (which we call directional hedge) which focus on equities. In general, these funds have given up some upside in exchange for avoiding drawdowns. They have done their job on a risk adjusted basis but have failed to keep pace with rising equity markets over the prior three years after performing reasonably well both during the 2008 crash and longer periods dating back to the 1970’s (posting equity-like returns with much less risk than the market).

2) Second, the issues that have plagued hedge funds have impacted virtually all active management strategies since 2008. Equity markets have been characterized by high volatility and “beta” driven movements where stocks tend to move rapidly up and down in unison. The percentage of active managers that have lagged their benchmarks has been unusually large. Hedge funds, because of their lower beta and higher fees, have been particularly susceptible to underperformance, but they are by no means alone.

The million dollar question: Is the most recent period indicative of a new trend?  Perhaps.

The last several years have experienced a fairly unusual phenomenon—a relatively high degree of correlation across stocks. Since many stocks are behaving similarly, it has been very challenging for active managers, and directional hedge fund managers in particular, to add value (alpha) through stock selection. We believe this development is the primary explanation for poor hedge fund returns. The real questions then are Why has this happened? and Will this high correlation across stocks continue?

Several anecdotal developments provide some clues. First, experts estimate that as much as 75% of daily trading activity is now attributable to indiscriminate investors: high frequency traders as well as index funds and exchange traded funds (ETFs). By indiscriminate, we mean purchase or sale decisions are being made based upon factors other than underlying fundamentals (e.g., attempting to capture relatively small moves in stocks prices or mimicking a popular index). If a large segment of investors is insensitive to the fundamentals of the stocks they buy or sell, it stands to reason that stocks will tend to behave more alike. As these types of investments command ever increasing proportions of daily trading activity, the theory goes, the more difficult it will be for hedge funds managers to generate enough excess return to warrant their high fees.

It is true that fundamentally indiscriminate decision-making and correlations across stocks are both up, but the former does not necessarily trigger the latter. Indexing and high frequency trading have been increasing proportionately for years, but the high correlations are more of a recent phenomenon.

Our opinion is that a different factor has been the primary culprit behind unusually high equity correlations: massive inter-market fund flows. With the 2008 bear market still clearly visible in the rearview mirror, investors have been inclined to flee from equities at the first sign of trouble. It has been termed the “risk on/risk off” trade and has been a global phenomenon. To meet these cash flow demands, fund managers and ETFs are forced to buy or sell wide swaths of stocks, causing most stocks to move in tandem – in the direction of the fund flows. We believe it is these inter-market fund flows, not intra-market investor behavior, that has caused the increase in stock correlation.

Equity markets have innumerable moving parts, so causality is difficult to “prove” here as well. However, we have witnessed a pattern of coincident increases in both investor panic and correlation across stocks (see chart). Over the past six years, each time we have seen a spike in the CBOE Volatility Index (termed VIX or the fear index), we have seen a spike in correlation. Conversely, we believe it is reasonable to assume that once investors become less fearful as a group, correlations will return to more normal levels where active management and hedge funds in particular, can add value.

Source: Bloomberg

Equity correlations have begun to come down in 2012 and active managers, including directional hedge funds, have performed better. Indeed, this environment could actually be nirvana for stock pickers. An extended period of high correlation among stocks could suggest that the gap between intrinsic value and price for certain stocks may actually be quite large. The increasing proportion of indiscriminate investors actually may help. With less investor capital competing to find mispriced securities, the truly skilled investor can separate more easily from the pack.

So are hedge funds dead? We believe the issue is far more nuanced. Periods of high correlation across stocks will come and go. These trends will result in cycles of relative underperformance for all active managers, including hedge funds. We have reduced our exposure to hedge strategies over the past 12 months for that reason. However, all businesses are not alike and we believe high correlations across stocks can’t persist forever. Ultimately arbitrage opportunities arise between good and bad stocks, creating an environment where active management can seek to add value.

The ultimate decision on hedge funds is very client specific. For certain clients, hedge funds are not a good fit, so we don’t invest in them. For other clients, hedge funds may provide valuable diversification and risk mitigation benefits. After the recent cycle of absolute underperformance, we maintain our conviction that select hedge fund managers possess the skills necessary to deliver returns; however, like a Hollywood starlet coming off of a box-office bomb, the burden of proof is on the managers to deliver the goods in the next installment.

Despite a rise in oil prices, commodities lagged a bit in the quarter, though gold performed well. The Federal Reserve believes recently rising energy prices will be transitory and inflation should remain contained. This will allow the Fed to keep a policy of low interest rates in place for some time, though many wonder if another round of quantitative easing will be on the table once “Operation Twist” rolls off. The Fed’s stance, along with ongoing
tepid economic growth, helped keep Treasury yields near historically low levels.

With regard to stocks and the economy, several issues could prove troublesome in the upcoming quarters. These include: a potential deterioration in certain European countries (which will likely experience slow growth regardless); a possible hard landing in China; an increase in oil prices; and the potential for ongoing slow growth in the U.S. economy and the waning stimulus to dampen corporate earnings and profits. Investor reaction to the U.S. presidential election is a wildcard, and uncertainty about the “fiscal cliff” (expiration of tax cuts alongside increased spending cuts) might keep a lid on investor enthusiasm. For Q1, at least, these worries took a backseat to optimism that the muddle-through recovery will stay on track.

To read more about Q1 market activity, click here.

To read more of the Global Financials Update, click here.

The book commences in the war room at the Applied Physics Laboratory where Rickards was invited by the Department of Defense to participate in a hypothetical war scenario, focused not on tanks and battleships, but rather on the use of currency as a tool for warfare.  Rickard warns the Department of Defense of the national security risk a currency war could cause.  His unique experience on Wall Street as a lawyer, economist and investment banker positions him perfectly to instill a sense of urgency. The next section of the book provides a great historical account of prior currency wars which occurred from 1921 to 1936 and 1967 to 1987 respectively.  With the burden of debt throughout much of the developed world compounded by a competitive bidding for a shrunken or at least slower growing global pie, the environment is ripe for another currency war.  Rickards emphasizes that when it starts to hurt at home, we first look to offload some of the pain to our neighbors.  By devaluing our currency, we make our economy more competitive in the global economy with an aim at improving domestic employment along with public sentiment.  He states, “Currency wars begin in an atmosphere of insufficient internal growth.  The country that starts down this road typically finds itself with high unemployment, low or declining growth, a weak banking sector and deteriorating public finances.  In these circumstances it is difficult to generate growth through purely internal means and the promotion of exports through a devalued currency becomes the growth engine of last resort.”

Rickards concludes his book with an exploration of potential paths the U.S. dollar might take.  He states, “The path of the dollar is unsustainable and therefore the dollar will not be sustained.  In time, the dollar will join a crowd of multiple reserve currencies, be subordinated to SDRs (Special Drawing Rights), be rejuvenated by gold or descend into chaos with both redemptive and terminal possibilities.”

“If you can’t imagine it, you can’t predict it” were the words of Gavin De Becker in his book, The Gift of Fear which I wrote about in a previous post.  Those words are apropos here as well.  Whether one agrees that the U.S. dollar’s future is at risk or not, Rickards’ book should be credited with expanding our imagination so that we are better positioned to make predictions about the future for global currencies.  I highly recommend adding this book to your collection as it is particularly timely and will stretch your mind.

For the last decade we have experienced below average returns in U.S. large cap equities including seemingly more frequent and powerful market declines.  In tandem with these below average returns, investment gurus everywhere, including the forward thinking university endowments and pension funds, have been promoting diversification outside of U.S. large cap equities into other asset classes, whether non-U.S. equities, real assets or more alpha oriented strategies including those that can be found in hedge fund structures.  The lesson that Mr. Rickles reminded me of is that you don’t always have to change to be successful.  It made me think how our recent experience in the markets may be coloring our view going forward.

The following chart displays performance across various asset classes for 2012 YTD (January through February), 2011 Calendar Year, and the ten and twenty-year annualized returns.  A couple of observations: (1) 2012 so far looks like the mirror opposite to the performance we experienced in 2011; (2) Large cap equities have suffered the worst ten-year return relative to their twenty-year return of any of the classes listed (blue dot below orange diamond).  Maybe it’s worth a look back at the basics as equity valuations have come down over the last decade.

Source: PerTrac

The data represented in the graph is based on the following indices: EM Equity – MSCI Emerging Markets Free Index, Small Cap Equity – Russell 2000 Index, Non-U.S. Developed Equity – MSCI EAFE Index, Large Cap Equity – S&P 500 Index, Global Real Estate – DJ Wilshire Global RESI (backfilled with FTSE NAREIT for the period prior to January 1993), High Yield Bonds – ML High Yield Master II Index, Commodities – DJ UBS Commodity Index, Treasuries (10+) – ML Treasury 10+ Index, Gold – Gold Price Index, Municipal Bonds – Barclays 5 Year Municipal Index, Cash – ML 3-month T-bills

The above returns represent various index returns with the intent of demonstrating historical behavior. No client has achieved these returns. You cannot invest directly in an index.

What is driving the markets? It appears to be, mainly, low yields for an extended period that are pushing folks up the risk spectrum while increased stimulus further supports risk assets. Depending on how you look at it, governments appear to be controlling the majority of the action, directly or indirectly. What is different, thus far, in this most recent rally is that correlations have come down and fundamentals appear to matter.  Time will tell if this is sustainable or if major global shocks will once again rule the day.

Source: Convergent Wealth Advisors

The above returns represent S&P 500 index returns with the intent of demonstrating historical behavior. No client has achieved these returns. You cannot invest directly in an index.

That math, however, is a little fuzzy as markets seldom act average. If one considers a reasonable expected return for stocks in any given calendar year to be between 5% and 15% (quite a wide range!), they might be surprised by how few years actually fall within those parameters. Over the past 85 years, the S&P 500 has logged a calendar-year return within those bounds only 15 times. Stocks more frequently end up hugging the extremes—either up big (more than one-third of calendar years are up 20+%) or disappointing (about a quarter posted negative returns).

Now we are not saying we expect a huge year for equities nor are we calling for the gains made thus far to evaporate. However, we do believe short-term market movements will likely catch many investors off guard one way or another. Considering the prospects for assets beyond short term noise and volatility, our preference is to take a longer-term approach to the markets. And while a pullback after a string of solid gains would not be out of the ordinary, in the long-term we think the attractiveness of stock valuations versus that of bonds balances out macro uncertainty and warrants continued levels of investment. That does not mean we are not actively managing portfolios or our assessment of risk. Rebalancing is certainly in order if allocations have gotten out of whack, as is keeping in place portfolio diversification and systemic hedges. But a reduction to stock allocations is not currently on the menu.

To read the full Market Pulse Report, click here.

Last week I was in San Francisco delivering a presentation to members of the Institute for Private Investors entitled “Rethinking Asset Allocation in the New World Order.” As I was preparing for the presentation, it crossed my mind that this title made two significant assumptions: (1) we must be unhappy with our allocations if we need to rethink them and  (2) we must believe something has fundamentally changed in order to suggest a “new world order.” As I considered these two issues, it hit me: sometimes we can get caught up in all the noise and lose focus on what is important. We often change course simply because we feel that our current course isn’t working. We often change to something we think would have worked without considering why our original path hasn’t lead to success.

While contemplating these assumptions and their repercussions, I was reminded of Billy Crystal twenty years ago in the movie City Slickers riding his horse next to Curly, the tough as nails, weathered cowboy played by the Oscar-award winning Jack Palance (Best Supporting Actor). In the film, Billy Crystal’s character was going through a mid-life crisis, trying to find himself as he went on a cattle drive adventure with a couple of his buddies. The scene replaying in my head was one in which Billy Crystal builds up the nerve to ask Jack Palance where he found meaning in life. Jack Palance, with his squinted eyes, leathery face and hand-rolled cigarette tucked neatly into the corner of his lips, holds up one finger and says “The secret of life… is just one thing.”  When Billy Crystal asks what that one thing is, Jack Palance responds, “You’ve got to figure it out for yourself.”

When I apply this message to the investment world, I’m reminded to:

1. Stay focused. When you look at a finger as you hold it in front of your face, everything in the background becomes blurry and highlights its lower relevance.
2. Keep it simple. Make a few key decisions correctly rather than trying to get everything right.
3. Seek the truth. Our own biases often keep us from finding the truth, so we must look internally to identify those biases, understand them, and set them aside.

Unlike winning an Oscar, when no one can take your trophy away once it’s on your shelf, an investor’s success over the short-term can be quickly revoked. The only Oscar that matters for an investor is the Lifetime Achievement Award, which honors years of building on success. It takes staying power and the ability to learn from one’s mistakes to reach such a milestone. I hope you all enjoy the return of Billy Crystal to the Oscar’s and will celebrate the 20th anniversary of Jack Palance’s Academy Award win by taking a few minutes to think about what matters most to you when it comes to your investments.

• Greek politicians continue negotiations with European leaders over a series of additional austerity measures in exchange for an additional $172 billion bailout from the IMF/EU/ECB. Greece faces a large debt payment in March and without the additional aid will be forced to default, a move that European leaders have been looking to avoid for several months. In exchange for the additional aid, European leaders are looking for spending cuts including a lower minimum wage, pension reductions, and government layoffs. The agreement and further austerity measures have been extremely unpopular in Greece and have led to widespread public protests and the resignation of several politicians.

• The Chinese annual inflation rate jumped to 4.5% in January, reversing a five month trend of lower inflation data. While the data had little immediate effect on the markets, analysts expect it to have an impact on the country’s ability to continue easing monetary policy.

• Despite recently losing its AAA credit rating, France drew strong investor demand at its first auction since the downgrade. The country sold over $10 billion in intermediate bonds but received bids for nearly $25 billion worth of securities. Spain was also able to successfully auction off approximately $8 billion at a yield of 5.4%, indicating that recent measures have eased debt concerns to an extent.

• A closely followed German business confidence index rose in January, beating economist’s expectations. Following a sharp slowdown in the fourth quarter of 2011, business activity in Germany appears to have picked up in January.

• This week John Chambers, Standard & Poor’s managing director of sovereign credit ratings, warned that the U.S. faces the prospect of another credit rating downgrade in the next 6 to 24 months. The firm continues to monitor the fiscal and monetary policy of the U.S. closely and would like to see a “credible medium-term fiscal plan.”

• On February 10, S&P downgraded 34 Italian banks and financial institutions after placing their ratings on watch late last year. S&P believes that Italy remains extremely vulnerable to financing risks given the high level of public debt and increasing borrowing costs.

Disclosure

The information contained in this summary is for informational purposes only and contains confidential and proprietary information that is subject to change without notice.  Any opinions expressed are current only as of the time made and are subject to change without notice.  This report may include estimates, projections or other forward looking statements, however, due to numerous factors, actual events may differ substantially from those presented. The graphs and tables making up this report have been based on unaudited, third-party data and performance information provided to us by one or more commercial databases.  While we believe this information to be reliable, Convergent bears no responsibility whatsoever for any errors or omissions.  Additionally, please be aware that past performance is not a guide to the future performance of any manager or strategy, and that the performance results displayed herein may have been adversely or favorably impacted by events and economic conditions that will not prevail in the future.  Therefore, caution must be used in inferring that these results are indicative of the future performance of any strategy. Index results assume the re-investment of all dividends and interest.  Moreover, the information provided is not intended to be, and should not be construed as, investment, legal or tax advice. Nothing contained herein should be construed as a recommendation or advice to purchase or sell any security, investment, or portfolio allocation.  Any investment advice provided by Convergent is client specific based on each clients’ risk tolerance and investment objectives.  Please consult your Convergent Advisor directly for investment advice related to your specific investment portfolio. Non-deposit investment products are not FDIC insured, are not deposits or other obligations of Convergent Wealth Advisors, are not guaranteed by Convergent Wealth Advisors and involve investment risks, including the possible loss of principal.