Why Investors may Want to Consider a Simple Strategy

Why Investors may Want to Consider a Simple Strategy

Those who fail to learn from history are doomed to repeat it.

George Santayana (Philosopher)

Before delving into history, overnight market action was positive for the share market.

The Dow Jones broke through the psychological 19,000-point level. This should bode well for the ASX today.

The US 10-year bond rate fell a little…perhaps the inflation fears have settled.

Gold remained steady…holding just above the US$1,200 an ounce mark.

The Aussie dollar strengthened a little against the major currencies.

Central bankers will be happy with this dashboard of market activity. Steady as she goes…minimal volatility.

Here’s an observation on market action post-Trump’s election win.

Groupthink has people believing President Trump will create inflation where all others have failed. The bond markets — longer-term interest rates — moved higher on the expectation of Trump’s proposed ‘spend-a-thon’ unleashing the dormant forces of inflation.

Personally, I’m not so sure. Obama increased US Federal debt by US$10 trillion, and yet the US economy still remains on emergency measures. The agonising over whether to increase interest rates by a whole 0.25% is pitiful.

Leading the horse to water is one thing, but making it drink is another. Unless Trump can generate genuine wages growth, households do not have the disposable income needed to trigger inflation. There is simply too much debt in the system.

For more than two decades, Japan has been trying all sorts of stimulus/crazy/ridiculous schemes to generate inflation…all they’ve succeeded in doing is building a mountain of unrepayable debt.

When you have a good chunk of the population moving into the economically unproductive phase of their life — retirement — inflation is not that easy to create.

The task is made even more difficult when those retirees are being placed on an income-starvation diet. How much worse will that spending restraint become if the assets, that yield hungry investors have been forced to buy, suddenly collapse in value?

In my opinion, deflation is not going away anytime soon.

That’s the present and future, but what can we learn from the past to make us smarter, more discerning investors?

But first, I have an investment opportunity for you. The fund is managed by some of the best and brightest investment brains in the business.

Past performance (after fees) has been:

  • Year 1: 20%
  • Year 2: 43%
  • Year 3: 41%
  • Year 4: 17%

 

Very impressive numbers.

Over this four-year period, the fund has grown from US$1.3 billion to around US$140 billion.

Not all of this growth is investor capital. The fund does have a considerable amount of leverage (debt). It’s this highly-leveraged position, in well-placed trades, that’s accelerated the rate of return.

With greater leverage comes greater risk.

This risk is being managed by a highly-credentialed and experienced investment team — including Wall Street veterans and two Nobel Prize winning laureates.

The Nobel Prizes were awarded in economic science…for work in developing the theory on how to price options. Seriously smart operators.

Are you interested in investing in this exceptional investment opportunity?

Before I tell you more about the fund, let me share with you the performance in its fifth year — MINUS 92%.

Investors were all but wiped out.

Still interested?

Even if you’re interested, the investment no longer exists. The fund was bailed out on 23 September 1998, and then liquidated.

It took several years for investors to be paid back cents in the dollar.

The investment was Long-Term Capital Management — LTCM.

Some of you may know the history of the fund. For others, LTCM is a lesson you should sear into your investment memory.

The fund was established in 1993 by legendary Wall Street trader John W Meriwether. Meriwether made his name at Salomon Brothers. When setting up LTCM, he recruited several key staff from his former employer.

In addition to surrounding himself with familiar faces, he was joined by Robert C Merton from Harvard University and Myron S Scholes from Stanford University.

The academics — and eventually Nobel Prize recipients — wanted to test their theories in the real world.

To give you an appreciation of the esteem Merton and Scholes were held in, the author of When Genius Failed, Roger Lowenstein, described their appointment as follows: ‘Long-Term had the equivalent of Michael Jordan and Muhammad Ali on the same team.

That’s a formidable team.

LTCM had serious academic and Wall Street cred. It’s easy to understand why the dollars poured into the fund.

Meriwether’s investment strategy was fairly straightforward: identify bonds that were either over or under-priced and wait for reversion to the mean.

To magnify the potential gains, LTCM used leverage (debt)…and heaps of it.

In Lowenstein’s book, he described the LTCM strategy as:

Leveraging its tiny margins like a high-volume grocer, sucking up nickel after nickel and multiplying the process a thousand times.

The strategy worked a treat in the early years — 20%, followed by 43% and then 41%. Excellent numbers. Performance that was good enough to lure in the big bucks.

The team at LTCM were not only making excellent gains for their clients — they, too, were doing quite nicely from management and performance fees.

In 1996, LTCM booked a profit of…US$2.1 billion. That’s US$40 million per week, 52 weeks of the year. Ka-chiiiing!

Now, that sort of money does not go unnoticed on Wall Street. Anyone wearing a tailored suit, with dollar bills running through their veins, wants a slice of that action.

Pretty soon, Wall Street figured out the strategy, and the thousands of ‘nickel and dime’ trades were being picked over by LTCM’s competitors. The fertile ground of mispriced bonds was turning barren.

In 1997, in an attempt to replicate the stellar performances of years two and three, two things happened — the fund added more leverage, and it moved away from its core area of investment expertise.

The fund’s leverage went from 18:1 to 28:1. What does that mean? The margin for error is wafer thin.

Imagine buying a home for $280,000 with $10,000 of your money and a $270,000 loan. For you to lose your money, the property only has to fall 3.7% in value.

Now, expand your imagination a little (OK, a lot), and think about what this means for a fund with US$140 billion — $5 billion of investor money and $135 billion of borrowed funds.

When markets can move 10% or 20% in a day, leverage on this scale was a disaster waiting to happen.

In 1997, the Asian crisis hit, and it was the beginning of the end for LTCM.

Ironically, as the LTCM high-performance vehicle developed a fatal case of the wobbles, Merton and Scholes were jetting off to Oslo to collect their Nobel Prizes.

In 1998, the losses mounted, and the fund collapsed.

What are the lessons from LTCM?

  • Past performance is not an indicator of future performance.
  • You need to know what you’re investing in to understand the risks you are exposing your capital to. If you don’t understand the investment, DO NOT invest…irrespective of how bright, talented and decorated the investment team might be. Hubris, greed and ego can be blinding agents to even the best and brightest.
  • Too much debt is a ticking time bomb.
  • Do not chase returns by straying into investment areas you are not familiar with. The markets have a way of punishing you for your ignorance.

 

Take these lessons and apply them to the world today.

The US share market has delivered an exceptional performance since 2009. But we know the market has been ably assisted by the Fed’s extraordinary stimulus actions.

But can the Fed repeat that performance in the coming years? I doubt it.

The debt time bomb is ticking away. The world is a far more indebted place than it was in 2008/09…this, too, is a disaster in waiting.

The best and brightest tell us all is OK with the economy…growth is coming anytime soon now. Believe this at your own peril.

The economy has too much debt. Too much capacity. Too many technological innovations coming. Too many retirees.

Finally, the need to lower interest rates (to keep debt levels rising) has forced investors to take on more risk to generate return.

The following pie charts show how investment strategies have transformed over the past 20 years to achieve a 7.5% rate of return.


Source: Callan Institute Research
[Click to enlarge]

The standard deviation (risk factor) has nearly trebled (from 6% to 17%) over the past two decades.

Simple strategies have been replaced by far more complex ones with a greater level of volatility.

The golden rule is: The more complex a strategy, the more moving parts there are to go wrong. Hence the higher risk rating.

In my opinion, the world is a giant LTCM — too much leverage, too much faith in academics who lack real-world experience, too much reliance on past performance, too much complexity, and a wafer thin margin for error.

History is about to be written…again.

Better to learn the mistakes from others than pay the very expensive price to learn them yourself.

Here’s my advice, LTCM — Leave the Complex Market.

Invest in a simple strategy where you know what your risks are and, for now, accept a lower rate of return. Keep your powder dry. History tells us there’ll be plenty of higher-yielding bargains available when complexity turns to chaos.

Regards,

Vern Gowdie,
For Markets and Money

Editor’s Note: Newman Show Hijacked! James Woodburn and Kris Sayce hijacked The Newman Show to discuss recent market news across Money Morning and Markets and Money.

Join Woody and Sayce for an informal discussion on…Trump infrastructure spending… where the money’s going…resource investment opportunities…how far the Aussie housing market has left to run…the war on cash… You can watch all that, and more, right here.

Vern Gowdie

Vern Gowdie

Editor at Markets & Money

Vern Gowdie has been involved in financial planning in Australia since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners.

His previous firm, Gowdie Financial Planning, was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top five financial planning firms in Australia.

He is a feature editor to Markets and Money and is Founder and Chairman of the Gowdie Family Wealth and the Gowdie Letter advisory services.

Vern Gowdie

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