Eight Years After the Apocalypse, What Have We Learned?

March 13, 2017

Occam's Razor states, all things being equal, the simplest explanation is usually the correct one.
Eight years after the Credit Crisis, the simplest explanation has not changed. Wall Street and the U.S. government were irresponsible actors in the run-up to 2008. Both behaved badly. And Main Street, literally and figuratively, paid the price.
But that is a story for another day.
Last week marked the eight-year anniversary of the 2009 bear-market low. Eight years ago, on Monday, March 9th, the S&P 500 closed at 676. 57 percent beneath its October 2007 high.
Shell-shocked investors believed the market would never recover.

What is comfortable is rarely profitable. And those who put money to work in March 2009 have been rewarded ever since. The S&P 500 has returned 14.88 percent annualized. And has not been down one year. Leaving analysts to quip that the current bull market, having ripened to eight years old, is due for a correction.
Only, their claims are facetious. For it was not until March of 2013, when the S&P 500 surpassed its 2007 high, that the bull began. Which renders it as middle-aged. Not the octogenarian such pundits proclaim it to be.
Until something changes, the trendline points upwards and right. Yet, other than compounding interest, no financial concept on the planet is more powerful nor dependable than mean reversion. At some point, when the animal spirits have regained a lusty swagger, stocks will fall. And investors, recalling the bear markets that dominated the first decade of the new century, will panic like the Tin Man in a thunderstorm.
Nor will I blame them.
Investors responded to the 2008 tumult in understandably human ways. Fight or flight kicked in. Sending many to the sidelines. Where they locked in their losses and missed out on the turnaround.
In fact, as of April 2015, 52 percent of American investors owned no equities. Even as stocks had risen 106 percent over the preceding six years. Annualizing at 17.6 percent.
Presented with one of the great buying opportunities in a lifetime, 52 percent of the nation sat upon the sidelines. Imprisoned by fear. Which condemns us to focus on the past. Even as we worry about the future.
What market historians and purveyors of hindsight miss is how poorly prepared investors were for market volatility of that magnitude.
For 25 years, Wall Street's parlor tricks had convinced Main Street investors that they need only invest in three asset classes: stocks, bonds and cash.
Ironically, as Wall Street claimed its taxpayer-funded bailouts, Main Street paid the price.
During both the 2000 and 2008 bear markets, some asset classes held up. Though few posted desirable returns. Desirable being a relative term. During bear markets, desirable is anything that loses little to no capital.
In 2008, the large stock market losses were exacerbated by a lack of investor preparedness stemming from woeful diversification habits. Habits developed over time as Wall Street lulled investors into a false sense of security. Bringing them to over-allocate to risk assets. Particularly to higher volatility areas of the global marketplace. Large, mid and small cap growth. Emerging market. High-beta technology concerns. Banks. Homebuilders. High-yield bonds. And any number of other categories that, like Icarus, flew too close to the sun.
Why were investors -- from the uninitiated to the most sophisticated -- so unprepared?
Traditional sources of diversification were mercilessly tested during a 17-month period in which there were few places to hide. Stocks, corporate bonds, emerging markets, commodities, real estate? All massively depreciated in unison.
So, did traditional asset allocation fail investors? Here, things get more complicated.
Traditional portfolio diversification -- the allocation of investment capital to stocks, bonds and cash - has not been so traditional, of late. In fact, Wall Street's biggest clients, the pensions, endowments, foundations and large corporate pools into which they sell their products, often count stocks, bonds and cash as a small facet of their allocations. Preferring to allocate capital to a multitude of low-correlation, low-volatility alternative investment classes.
But, where Main Street is concerned, Wall Street has maintained business as usual. Stocks, bonds and cash. Only, those failed to lower volatility. And provided no protection against the massive losses suffered by so many.
More astute investors might question the validity of focusing one's investment efforts around three asset classes. And yet, for our purposes, an explanation can be found by considering the traditional relationship between Wall Street and Main Street.
Following the passage of the 1970s ERISA laws, Americans who had never invested began doing so. The ranks of those seeking to place retirement capital into the markets swelled. And Wall Street was there. Dispensing advice and selling product.
Wall Street's bread is buttered through the accumulation of assets. And Wall Street is nothing if not an efficient sales machine. Accordingly, Wall Street created a variety of investment products that enabled advisors cum salesmen to spend time gathering new assets as opposed to managing what they had. And to keep it simple, Wall Street's minions focused on three primary asset classes: stocks, bonds and cash.
Leading into the tech bubble, the belief that investors need only diversify between three primary asset classes had become commonplace. When the market fell apart from 2000 to 2002, investors were scared. But the 2000 bear market differed from 2008. Because that downturn featured a number of equity and fixed-income categories that held up reasonably well.
The tech-bubble bear focused largely on large cap growth stocks. With other asset classes posting gains and/or smaller losses. So investors were weary but not shell-shocked. And quickly returned when equities bottomed in 2002.
In the 1970s, an investor could aptly diversify with 100 stocks. Since then, the financial system has become more complicated. Correlations between stocks have risen. Sometimes to the point of perfect correlation. Meaning that stocks of all different sizes and geographies rise and fall in unison. As opposed to independently. Which has been very detrimental to what investors perceived as the traditional benefits of diversification.
Even stocks and bonds have increased in their propensity to mirror each other.
So when U.S. stocks fall, foreign developed and emerging markets often join them. And during periods of hyper volatility, corporate bonds may lose value. Leaving average investors with no place to hide.
Wall Street hasn't helped.
The big banks and brokerages recognized that the tide was coming in. But they were making too much money to muster the required effort to educate Main Street investors. More sophisticated clients, the largest pools of capital out there, already understood the merits of alternative asset classes. But small investors were a different story. So Wall Street chose not to fix what appeared unbroken. And continued to diversify with stocks, bonds and cash.
When the Credit Crisis hit, investors -- especially those on Main Street -- were wholly unprepared.
2008 showed that investors seeking diversification require more than a traditional allocation to stocks, bonds and cash. In fact, among the few asset classes left standing in 2008 were certain bonds and alternative investments.
The term "alternative investments" includes any investment that is insulated from fluctuations in the public debt or equities markets. These can include private debt, private equity, hedge funds, and real estate. And they can act as a hedge to help protect principal against downside risk in the broader market.
Managed futures. Treasuries. Mortgage-backed securities. Short-duration bonds. Global macro hedge funds. Municipal bonds. Private equity. In 2008's sea of volatility? These investments were islands of tranquility.
If investors hope to more effectively weather future downturns? Alternative thinking is required.
True portfolio diversification, the kind that provides investors an opportunity to survive bear markets and fight another day, must include low-correlation, alternative asset classes. As should any portfolio that aspires to more than simply tracking stock-market indexes.
What constitutes an "alternative investment?" One residing outside of traditional stocks, bond and cash allocations. The benefit of which boils down to two primary ideas:
1) Alternative investment managers generally seek a net positive annual return. They don't track a benchmark index like the S&P 500 or the Barclay's Aggregate Bond Market. They don't proclaim victory when they beat the S&P 500 index by 1.3 percent even as the index lost 39 percent. They seek to deliver a positive return. Year in and year out. Doesn't always happen. But that's the objective.
2) Alternative investments can provide portfolio diversification while often reducing portfolio risk. Some are specifically designed to mitigate risk. While others do so by working alongside asset classes to which they have little-to-no correlation. Enabling them to perform independently of each other in all market environments.
Average investors, utilizing ETFs, mutual funds or individual stocks, require stock market growth if capital is to do the same. Occasionally, however, markets don't cooperate.
There have been 13 bear markets -- declines of 20-percent or more with no immediate recovery -- in the postwar era. The average lasting 362 days.
In each of these, stock-and-bond portfolios fared poorly. In the long run? Stocks recover. But that doesn't assuage the mental angst incurred during a downturn. Let alone knowing that every 30 percent decline requires a 43 percent gain just to return to par value.
Remember, it took the S&P 500 until March of 2013 to surpass its 2007 high.
John Maynard Keynes said, "In the long run, we're all dead." But it was likely an alternative investment management who added, "Neither you nor your portfolio need die prematurely."
So, if you can utilize investments that enhance the probability of success throughout market cycles, why wouldn't you?
Private equity has been the top-performing asset class over the last 25 years. According to Cambridge Associates, it has outperformed the S&P 500 as well as the Russell 2000 small-cap index over the 5-, 10-, 15-, 20- and 25 year periods. In fact, the last quarter century has seen private equity return 13.4 percent per year, while small cap stocks delivered 10.6 percent, and the S&P 500 provided 9.9 percent.
Moreover, private equity has done so with a negative correlation to the S&P 500. Meaning, P.E. returns have been independent of large cap stocks.
Performance itself, however, is hardly the only point. Because many alternative investments can improve long-term portfolio management endeavors simply by adding a lack of correlation to traditional asset classes. Helping to lower a portfolio's overall volatility.
Studies prove that the addition of alternative investments to portfolios often improves performance while lowering volatility. Which merits their consideration in any investment endeavor. Just by taking a bit from stocks and bonds, as the image shows, and adding to alternatives, improves returns and lowers volatility in every risk sample.
Which explains why the largest, smartest and most successfully managed pools of capital in the world allocate the majority of capital to alternative asset classes like private equity, managed futures, hedge funds and real estate.
Over the years, Yale's endowment has made increasing allocations to alternative investments. To such an extent that in 2015, domestic and foreign stocks amounted to only 19 percent of the Yale's portfolio. Whereas alternative investments comprised 51 percent of the portfolio.
Nor is Yale alone. The "endowment model" model, based upon large allocations to alternative and low-correlation asset classes, has been adopted by endowments, pensions, foundations and other large pools of sophisticated investment capital.
Unfortunately, most Main Street investors still believe that such opportunities lay well beyond their means. That alternative investments are strictly for institutions and wealthy individuals. While that use to be true, today's alternative investments industry has democratized.
Our firm has sought out a variety of opportunities available to all investor classes. As we wanted to diversify into alternative asset classes with all clients. Not just the wealthiest.
Do alternative investments represent a magic elixir? The ticket to curing all investment woes? Of course not. Like any investment, alternatives must be carefully scrutinized before being appropriated. They can be risky. Involve loss.
That said, the risks of not utilizing alternative investments have been firmly established. Two times in the last 15 years. Bringing pragmatic investors to move from the traditional asset allocation methods to a more modernized, nuanced approach. To expand upon traditional stock and bond portfolios by adding commodities, private equity, hedge funds and real estate.
Thus far, investors have been limited because Wall Street -- in its never-ending effort to gather additional assets without adding additional work -- has largely focused on stocks, bonds and cash. Even as the executives of the big banks and brokerages stuffed their capital into alternative investments.
Hedge fund manager Ray Dalio counseled, "I think the first thing you should have is a strategic asset allocation mix that assumes that you don't know what the future is going to hold."
The risk of not doing so is simply too great. We inhabit a world comprised of 6.5 billion people. Most engaging in financial transactions of one sort or another. The sheer magnitude of today's interconnected global financial system means that we can no longer invest as we used to. We must adopt a more sophisticated approach for an increasingly complex world.
Pragmatic investors should consider opportunities beyond stocks, bonds and cash. Should climb outside of the box in which Wall Street's brokerages have long kept them.
The world has evolved. Main Street investors can and should do the same.

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Advisory Services offered through Dempsey Lord Smith, LLC, an SEC Registered Investment Advisor. Clearing through and accounts held at Charles Schwab & Co., Inc.

Dempsey Lord Smith, LLC nor Hyde Park Wealth Advisors LLC provides tax or legal advice and you should consult your accountant and/or attorney if considering an investment of this type. Hyde Park Wealth Advisors LLC is not controlled by or a subsidiary of Dempsey Lord Smith LLC. Investing in Alternative Investments come with a variety of risks that could result in a complete loss of principal investment.

Alternative Investments offered as private placement securities are offered only to qualified accredited investors via confidential private placement memorandum. Income and returns are not guaranteed and there are no assurances investments will meet their stated objectives.

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