The investment strategy I set forth in this book is not a stock-picker’s method. Lots of people still think this is what investing is all about—finding those diamond stocks in the rough that will deliver wealth and all the trappings of Easy Street. There’s nothing at all wrong with stock picking, which, when practiced with an eye to detail, has made many an investor rich. At the micro level, finding the best companies—based on profits, product lines, market shares, P/E ratios, stock multiples, etc.—within the best-performing sectors is a rigor taken on by many successful investors. But my investment plan specifically is concerned with the big picture, with the broad macro worldwide forces that act on all investments.
In essence, my method applies a set of “top-down” principles that enable you to accurately select the winning asset classes within each economic “cycle” or definable economic period (typically between a point of low performance to one of high performance). Intrinsic to this strategy is the belief that the separate asset classes—such as the stocks of large or small companies, or the shares of domestic or international corporations—each act in ways that are uniquely attached to the full range of economic variables.
Here’s an example: In 1964, a tax cut was signed into law that lowered the top income-tax rate from 91 percent to 71 percent. If you think 91 percent was quite high—confiscatory, to say the least—you are correct. So lowering that rate assuredly would have made some taxpayers happy. Let’s measure how happy:
A 91 percent tax rate leaves only 9 take-home cents per dollar of income. When that tax rate is reduced to 71 percent, the take-home increases to 29¢. Thus, the 1964 tax-rate cut more than tripled the take-home rate for high-end earners subject to this tax.
Because high-end earners back in 1964 suddenly had more capital available, they were able to put it into action by investing it, saving it, spending it, expanding their businesses, and perhaps hiring more workers. All these activities are positives for economies, and the economy of the mid-1960s was no exception.
The 1964 income-tax cut, coupled with the tax cuts of 1962 on investment and capital gains, helped activate one of the longer economic expansions in American history: Unemployment declined from 6.7 percent to 3.8 percent in 1963; capacity utilization (a measure of the output of factories and industries) increased more than 8 percentage points to 91.9 percent in 1966; the real gross national product (GNP) grew at a compound annual rate of 5.7 percent between 1963 and 1966, compared with just 4.1 percent during the previous three years; and while government spending expanded 5 percent more than GNP between 1960 and 1963, GNP grew slightly faster than government spending between 1963 and 1966.
I point out the rate of spending in relation to the rate of economic growth (or GNP growth) because it has been argued that the increase in economic activity during this period was a result of accelerated government spending. But with the ratio of spending to growth falling, it becomes clear that the tax cuts strongly contributed to the economic expansion.[1][2]
Two quick notes are in order. To present my investment strategy using the cocktail-economics approach, my methodology has necessarily become more specific. First, instead of merely jumping off random editorials in the Wall Street Journal, I use historic examples to illustrate and explain the key big-picture concepts of investing explored in each chapter. A second important distinction is that the macroeconomic analyses contained herein are not dependent on a person’s political leanings. That tax cut of 1964, for instance, was not a Republican event, with the GOP being the party most often associated with the desire to lower tax rates. The 1964 rate cut was shepherded by Democratic President John F. Kennedy and signed into law by his Democratic successor, Lyndon B. Johnson.
Facts matter more than politics. And what matters most to a successful investment strategy is both the quality of the economic analysis and the insights derived from that analysis. This is a lot like cocktail economics—a correct filtering of information is essential. But what I provide in these pages is a framework of filters that have proven over many years to accurately identify which asset classes will perform best (or worst, or neutral) in each economic environment. Can asset-class swings be predicted? Yes. Furthermore, as investors, can we time our actions to those swings? Yes again.
This might sound like powerful stuff, and it is. In my experience, any investor who faithfully applies such a program has little option but to perform better than the great many investors who do not.
Much better.
Beyond random luck, foul play, or a highly tuned ability to pick stocks company by company, truly successful long-term investing cannot occur without a sound idea of how the many top-down macroeconomic forces—taxes, regulations, inflation, interest rates, war, peace, trade barriers, etc.—act on the investment vehicles themselves. And here I stress the idea of truly successful.
Too many financial planners and advisors have investors believing that average is good enough. To be sure, average is not bad. If you invest in a broad range of stocks and bonds and stick to your allocation decisions for a long enough time period, you are certain to come out ahead. And ahead, in this case, will likely be near the middle of the pack. But what if I told you there is a way to capture the upside of each economic cycle that will have you ahead of the pack for most of your investment life? You might hesitate, thinking you were being sold a get-rich-quick scheme—which, assuredly, is not my plan. Rather, this book sets forth an intuitive approach to investing that takes into account all the macroeconomic forces that act on the performance of every possible asset class. When these forces are understood, an economic cycle can be described in terms of how the different asset classes will perform in it. With this knowledge secure, all an investor needs to do is shift to the asset classes that are forecast to rise and step away from the ones that predictably will fall—or do nothing at all, if staying put is the best course of action.
If I told you that road accidents are likely to increase in foul weather, you might yawn in response. Everyone knows that. But if I said that small-capitalization stocks (shares of public companies that are relatively small in size) are likely to do better than larger company stocks in uncertain economic environments, such as when new regulations or higher taxes have been set into place or threaten to be signed into law, I might get your attention.
This is but one of several provable relationships between the macroeconomic environment and the separate asset classes that we discuss. These relationships are easy to learn and, if you invest, to apply. But I stress that it is important for the investor interested in true success to understand all the variables that make for the relationship between economic policy and asset-class movement. Simply, successful investors need to know why groups of stocks do what they do.
Why? Let’s go back on the road.
Why are there more car accidents in inclement weather? Several factors might be at play: lower visibility, slick road surfaces, inadequate equipment, the random driver who makes hell for everyone else. You know all these, and successful drivers take each of these factors into account. Another yawn. But what if I were to ask, “Why do small-caps perform better than large-caps in uncertain economic environments?” The key factor here might be the capability of a smaller company to adjust to a new economic environment more quickly than a larger company—something akin to a sprinter being able to beat out a long-distance runner, if only at the start of a race. Someone who yawns at this relationship just might not be interested in making money.
I have written somewhat academically about these relationships in a book called Understanding Asset Allocation, a work I am very proud of that sets forth my strategy for cyclical asset allocation in an in-depth, analytical manner. By “cyclical,” I mean cycles—the prices of investment assets move in certain directions during specific economic environments for a knowable set of reasons. By “analytical,” I mean plenty of charts, historical data, theorems, formulas, and scrutiny. The subject in the pages ahead is the same. But hopefully I have presented it as if I were back talking to my business students at USC. In essence, where my previous book was an analytical study, this book is practical. Just as my students looked for practical ways to apply the economic theories forced upon them, I here set forth how truly successful investing is a product of a practical application of one’s sound understanding of the various macroeconomic forces.
Simply, if the prices of stocks and bonds will move in predictable directions when certain economic conditions are in play, there’s no reason for an investor not to act on that information.
In what follows, I offer snapshots of how this book attempts to bring you to this point of confidence.
My initial task is to impress upon you the importance of investing in general. I know of no sounder activity for wealth accumulation, if properly performed, than investing in a mix of stocks and bonds over the long haul. And at no time in history have more Americans been involved in this activity. Still, not every American is convinced. It’s common to run into folks who think of Wall Street as just another Las Vegas, people who believe that the risks of investing seems too great while the returns appear too random. I know this to be hogwash. But I’d still like to convince you, for certain, that investing in the markets is as sound and prudent an activity as you can be involved in—as sound as, say, owning a house.
Who doesn’t want to own a house, doesn’t see the value in it? Scant few. Hence, if you can understand why home ownership is vital to your wealth and security over the long run, I believe you’ll have no difficulty comprehending how long-term investing in the stock and bond markets is crucial to your financial well-being.
The follow-up to this is that not all investing plans are alike. As I noted, too many investors have been lured into the belief that average gains are the best they can hope for. Sure, average is not bad at all. If you purchased a broad group of stocks 25 years ago and sold that allocation today, you might be looking at triple-digit capital gains (as measured by share-price appreciation), generally and historically speaking.
Just for fun, let’s look at some of the big winners during this period. If you owned a share of Coleco Industries, the makers of the Cabbage Patch doll and Donkey Kong, for the last 25 years, you would have witnessed its price increase by more than 434 percent. If you bought and held Chrysler, you would have seen a 426 percent gain. Reading & Bates, the offshore drilling company? That stock climbed just over 181 percent in the last 25 years.
But now I’m sounding like a stock picker. Chances are, few people bought and held shares of just one of these stocks for the last two and a half decades. Chances are, most investors in this period purchased and held a variety of stocks and bonds. And in doing so, they acted just like homeowners: They bought, they held, and when the time was right, they sold, at a healthy profit.
But a lot went on while they were holding their investments. The prices of their shares went up and down or stayed flat, periodically and often violently—and not just company by company, but group by group. Their small-caps might have climbed while their large-caps wallowed; their value stocks might have gone on a tear while their growth stocks descended; their domestic stocks might have nudged tentatively upward while their international shares charged significantly higher.
If you involve yourself in a broad allocation and spread out your investments across the major classes of stocks and bonds in proportion to their market capitalization, over time you will do well. But in doing so, you will never capture (except by the whim of your original allocation) all the upside when one class of stocks breaks away from the pack. Meanwhile, you always will capture (again, by the whim of your original allocation) the downside movement of each class of stocks and bonds you hold. But all this will average out for you, if only because the average long-run upward performance of asset classes is for real. In other words, groups of assets that move away for a period from their long-run performance averages tend to return to their long-run performance averages. Wall Street types call this “mean reversion.” So if you buy and hold your portfolio of stocks and bonds, just as you would buy and hold a house, but perhaps adding to your portfolio paycheck to paycheck (just as you might with a 401[k] plan), you will gain by the average long-run performance of your original allocation. Not bad at all. But not great. This book is interested in great.
In an up-trending market, all investors like to own the stocks or groups of stocks that have the greatest sensitivity to the market—or the stocks that will climb the most when the market is rising. Pinpointing which group of stocks or asset class will do this and at what times is the essence of my program for investing. Because there is little or no chance that stocks will generate negative returns over the long run, by buying and holding the most sensitive stocks at the right times, you maximize your long-run returns. But how does one identify such sensitivity?
Let’s return to cocktail economics. I asked my students at USC to initially determine which segment of the economy would be affected by a policy action coming out of Washington, D.C.—or, for that matter any shock, from new taxes to new technologies, to global political events—that can impact an economy. Next, they were to determine which side of the market, supply or demand, would be affected by the shock. The final step was to determine the price changes and/or output changes that would return the market to its equilibrium. (Just as with stocks, economies or markets tend to return to their long-run levels of performance.) This brought up the concept of sensitivity, a term I often use interchangeably with flexibility or elasticity. Just like rubber bands, certain aspects of economies—such as companies, industries, production capacities, and resources—are elastic in nature; they can adjust lower or higher to meet the requirements of demand or supply. Conversely, just like oak trees, certain aspects of economies are stubborn and immovable. It follows that an understanding of which variables will bend and which will not is central to figuring out which stocks will outperform or underperform when economic shocks occur.
In many cases the all-important study of elasticity applies to location: the physical location of a company, a resource, a policy action, a natural occurrence, etc. Within these parameters, an elastic or flexible company might be one that shifts its production away from a suddenly high-regulation area to another in which the regulatory burden is much lower. An inflexible company, on the other hand, might see half its production capacity destroyed by a tsunami, with no capability to locate that lost production elsewhere.
Taken to a broader level, the investor who can correctly identify the elasticities inherent in classes of stocks possesses an excellent tool for determining the winners and losers through each economic cycle.
Over the years, I have found that the energy sector provides a wealth of examples for this “location effect.” Remember those rolling blackouts in California a few years back? In the simplest of terms, this shock occurred because the added demand for power in the state outpaced the capability of suppliers to deliver it. So put yourself back in my class at USC for a moment. Which companies would be best suited to survive this shock, and which would be most hurt by it? Thinking in terms of location, the California companies with inflexible or inelastic modes of production would clearly suffer the most: If Company A has two plants, one in Santa Barbara and the other in San Diego, there is simply no way it can escape an energy shock within California. In contrast, if Company B also has two plants, but located in San Francisco and Santa Fe, it has an immediate advantage over Company A if it can shift production to its New Mexico facility.
This is a very quick rendering of the location effect, and we examine it in greater detail later. But the idea should be clear to any investor: Always determine the impact of an economic shock in terms of both location and the elasticities of the companies in that location.
Over the years, I often have turned to energy as a way of illuminating even the most basic principles of investing—in particular, the idea that no one should ever put all his eggs in one basket. Investors like one thing above all else: higher returns, regardless of the asset classes that provide it. Similarly, in the winter, people in cold climates (for the sake of argument) might like one thing above all else: warmth at a good price, regardless of the fuel source that provides it. In both cases, the source of the result pales in importance to the result itself.
In the most pragmatic sense, investors want to make money. They do so by investing in small-caps, large-caps, value stocks, growth stocks, international shares, domestic shares, Treasury bonds, T-bills, and various combinations of each. People in cold climates, meanwhile, want to stay warm in the winter without going bankrupt. They look for the best-priced fuel they can bring into their homes, alter their fuel usage, better insulate their homes, etc.—anything to keep their energy bills within budget while staying warm. This simple logic instructs that the various sources of the results we seek ought to be correctly chosen to provide us with the sought-after results.
One period in American history bears out this parallel in a most instructive way: the energy crisis of the 1970s. Investigating this decade from the point of view of fuel—the source that would deliver American consumers their desired result—most interestingly enables us to construct a “benchmark” portfolio that is properly allocated for the long term. But remember, we’re interested in capturing all the upside the market has to offer. So by “benchmark,” I mean “beginning”—a thoughtful distribution of your eggs (your money) into several baskets (the various asset classes). And from this allocation you tilt from time to time based on your ability to properly evaluate each macroeconomic shock that comes along.
Tilting properly, however, requires some talent, and you need to develop a certain skill set to mature from an average investor to an above-average performer. Sadly, insight regarding the interrelationship of investing and economics is too often lacking these days. For instance, it never ceases to amaze me when a business story in the newspaper makes an inference about the profitability of a company, the performance of the stock market, or a macroeconomic variable such as the rate of GDP growth by looking solely at price changes. What can an increase or decrease in the price of something tell us about the profits that thing is generating or the quantities of it that are being transacted? The answer is, not very much. And without knowledge of profit and quantity shifts, we cannot make informed decisions on how to respond to news of a price shift. The challenge, then, is to discover the supply-and-demand conditions underlying movements in price (in effect, pinpointing the true nature of each economic shock) to make that price movement a reliable indicator. In this way, we turn what I call price “smoke” into a price “signal,” a valuable piece of information that enables you to act properly within your portfolio.
When the nature of an economic shock and the elasticities of the different companies, industries, and asset classes with respect to that shock are determined, a simple investment strategy emerges: Buy the stocks of the companies or asset classes that will benefit from the shock and avoid those that will not. This strategy has paid enormous dividends for my clients over the years. But it also has asked my clients to look more sharply at macroeconomic forces than ever before and to understand, that for every economic action, there is a predictable market reaction. As a result, the better my clients have understood these relationships, the further in advance they have been able to make the proper adjustments to the portfolios they manage.
Timing is an essential element of a cyclical asset-allocation strategy, although you will still benefit if you correctly adjust your allocations after an economic cycle has established. That said, you want to activate your tilts early enough to capture as much of a cycle’s upside as possible. This is not to say that investment forecasts based on a sound rendering of the macroeconomic environment will be correct every time; sometimes the forecasts will be off.
It’s just like the weather, an analogy I incorporate to describe the fundamentals of forecasting and timing. Sometimes it rains when the weatherman predicted sun, and other times it is sunny when the forecast called for showers. But the farmer out in the field always has a hand up on the weatherman. When he sees black storm clouds on the horizon, he can make the safe assumption that bad weather is coming and pull his tractor into the barn. In doing so, he uses additional information to his advantage. Or, in the abstract, he has applied his educated rendering of the variables to his decision rules for when or when not to take action.
This information advantage applies to the investment strategy I’m setting forth. The better you get at it, the easier it will be for you to timely apply a macroeconomic analysis to your decision rules for when and how to adjust your investments. You want to stay as close to top-down information as possible, essentially becoming the farmer who watches the skies, not just the weatherman who looks at the radar. In fact, it’s preferable that you wear both these hats.
Tax- and monetary-policy changes, natural disasters, shifts to the underlying inflation rate and the rate of GDP growth—these and many other events constitute shocks to the economic system and dictate periods when certain types of assets will outperform others. Here you want to wear the farmer’s hat: If you can see the storm clouds as they relate to these events, you very well might be able to anticipate cyclical changes in the economy and the stock markets they will deliver. To improve this forecast, you want to put on your weatherman hat, collecting the forecasts of seasoned pros who can corroborate your opinions.
Indeed, don’t get the feeling that you’ll be left standing out in the field gazing into the sky, attempting to figure out the relationships between economic shocks and investing on your own. Throughout this book, I outline the precise conditions under which the exposure to the various classifications of stocks and/or bonds should be increased or decreased. Then, using historical data, I illustrate the potentially significant benefits of such a cycle-driven strategy.
Shocks, cycles, elasticities, location effects—this investing story has many twists and also many levels of convergence. In the pages ahead, I also describe how the various macroeconomic forces might or might not move independently of one another and show that there is no way to rule out the fact that some conditions might occur simultaneously. This means that investors can employ multiple investment strategies either alone or simultaneously. What are these strategies?
Investors today might be most familiar with “passive” strategies that invest in shares of funds that mirror the performance of the various stock indexes. When the market goes up, the passive investor does well. When the market drops, the passive investor goes down with it. As the prices of stocks collectively move upward over time, this is a very safe strategy for long-term wealth accumulation. And although it is not, in my firm belief, the best method for attaining all the upside that markets have to offer, there are certainly times when an all or partial passive approach to investing makes the most sense. Similarly, sometimes going “active” is preferable—times when you want to select stocks in certain categories that will benefit most from the macroeconomic environment.
For instance, when the stocks of smaller companies (small-caps) project to outperform the stocks of larger companies (large-caps), my research bears out that an active, stock-picking approach to small-caps might be in order. Another approach concerns uncorrelated or nontraditional investments that are chosen on the belief that they will outperform the market for some reason. Hedge funds, which employ sophisticated investment strategies, fall into this category. The fees can be high for entry into these funds. But sometimes you want to stick your toe into these high-end active waters, just as sometimes a long swim in the lower-end passive pool makes the most sense.
You might notice that there is a “pair-wise” default to this investment program. Sometimes you want to lean large-cap, other times small-cap. Sometimes you want to go “active,” other times “passive.” So although there appear to be many moving parts to this plan, the implementation will not be too complicated as long as you keep in mind that there always will be one choice over another when it comes down to the nitty-gritty of adjusting your portfolio from time to time and from cycle to cycle.
Before we jump in, I’d like to leave you with a very cocktail-economics way of thinking about the application of this strategy. Question: How do you turn a martini into a Gibson? Answer: You put an onion in it. And if you’ll allow the gin and vermouth in the glass to represent the sphere of economic forces, the onion in the glass can represent the range of investment decisions you can make based on your rendering of these forces. Onions have layers, just like this multilayered investment plan. The first layer consists of building a benchmark allocation to the various asset classes. The second layer consists of an application of a macroeconomic forecast to one of four different pair-wise asset choices: large-cap versus small-cap, domestic versus international, value versus growth, and stocks versus bonds. The third and final layer consists of deciding among the various active and passive strategies. The end result is a cyclical asset allocation that will have you best positioned to take the most advantage of the stock and bond markets through every economic cycle.
Glass, for now, dismissed.