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From Seeking Alpha: Positioning for 2012 series
James Kostohryz is a proprietary investor and trader. He also serves institutions as a portfolio consultant specializing in global investment strategy. James was formerly Global Strategist and Head of Global Equity Proprietary Trading for a major financial institution. Kostohryz graduated with honors from both Stanford University and Harvard Law School.
Seeking Alpha's Jonathan Liss recently spoke with James to find out how he planned to position clients in 2012 in light of his understanding of how a range of macro-economic and geopolitical trends were likely to unfold in the coming year.
Portfolio Construction
Seeking Alpha (SA): How would you generally describe your investing style/philosophy?
James Kostohryz (JK): My investment philosophy is highly unconventional within the investment world.
My view is that for the vast majority of ordinary investors, being fully invested (as their default asset allocation) leads to mediocre performance at best – and will most likely lead to bad performance. This is true for two reasons.
First, by definition average investors have no competitive advantage as stock or fund pickers. Thus, mediocre performance is by definition the best most fully invested average investors can ever hope for.
Second, being passively fully invested means that investors will be overexposed to equities during bear markets. It is my view that it is both dangerous and unrealistic to expect average investors to hold on to investment positions during bear market cycles. Most investors are not emotionally equipped to handle conditions in which large losses of perceived wealth are sustained and even greater losses are feared.
Despite all of the warnings by the investment industry to stay fully invested, mass fear during bear market cycles causes most investors to sell at or near the bottom. Subsequently, these same investors only get back into markets when all seems well and market prices are at or near tops. This sort of behavior is almost inevitable for most individuals and it obviously results in sub-par performance.
As a result, I believe that the default position for most investors should be to hold a very high weighting of relatively risk-free investments such as cash and short-term bonds. I believe that a high weighting towards risky assets such as equities should only be made if and when a high level of conviction in an investment thesis has been developed in which favorable macro, micro and technical factors converge. In particular, investors should deploy cash after the equity markets have sustained large losses.
As a practical matter, this means a successful investment strategy for most individuals must place a primary emphasis on avoiding bear markets. This implies being willing to take profits during bull markets and leaving potentially illusory gains “on the table.”
By studiously avoiding bear markets, investors will be more financially and emotionally equipped to purchase stocks when the herd is selling, valuations are cheap and long-term expected returns are optimal.
SA: Which asset classes are you overweight? Which are you underweight? Why?
JK: I am strongly overweight cash. I am underweight or short every other asset class. At present time, economic and financial risks are at historic dimensions. I believe that cash is by far the best investment at this time on a reward/risk basis. High cash positions will enable investors to avoid huge risks and potentially take advantage of enormous opportunities in 2012.
Investors should make a special effort to invest their cash with an emphasis on safety over yield. I repeat, safety over yield is key. Investors should not make the mistake of investing in riskier money market or other fixed-income instruments in order to gain a few basis points of additional yield. Most investors have no idea how much additional incremental risk they are assuming when they stretch for a mere 20-50 basis point of additional yield in today’s environment.
In particular, with respect to money market funds and short-term bond funds, investors should take care to only invest in funds that are not exposed to Europe or any other international market. Currently, on average, roughly 35% of all US money market fund assets are invested in European instruments – and the vast majority of that is loans to European banks that are on the verge of insolvency. Note that one of the reasons that many US money market fund managers invest in European and international banks (and other companies) via the short-term money markets is to stretch for a few basis points of additional yield to entice clients given the extremely low interest rates in the US.
Investors need to take responsibility for their portfolios and actively avoid this inadvertent exposure to European and other international banks and companies in their portfolios.
SA: But in today's global economy, doesn’t holding a large cash position expose US investors to currency risk from inflation and/or a weakening dollar?
JK: Assessing risks to the USD is always a matter of relative rather than absolute valuation. When dealing with currencies, the question is: What currency would you rather hold? Would you rather hold the euro, a currency whose very basis is being questioned? Would you rather hold the currencies of commodity intensive countries such as Australia, South Africa or Canada in a context in which a global economic and financial crisis will certainly bring about a collapse in the value of virtually all commodities? Would you rather hold the Yen, the currency of a country highly levered to global growth, and with the highest public debt to GDP ratio in the world? Would you rather hold the RMB, the currency of a country that is highly leveraged to global growth and whose economy is on the verge of experiencing a major collapse in its real estate sector?
The fact of the matter is that on the basis of relative fundamentals the USD is the most solid currency in the world right now and is likely to benefit, in relative terms, from global economic and financial instability.
Now, some might argue that the value of the USD could fall relative to the value of other assets. The overwhelming risks are just the opposite. The world is on the verge of experiencing a severe bout of asset price deflation. The prices of everything from stocks, to real estate to commodities are poised to collapse relative to the value of the USD.
Many people believe that holding cash can only result in a deterioration of wealth. This is false. Holding cash in a time of asset price deflation will make you wealthy. Your net worth will rise when measured in units of productive wealth generating assets.
SA: 2010-11 saw a notable rush for the exits from equities and equity vehicles. Is this a cyclical, or secular shift? What would it take to bring them back?
JK: I would like to correct the premise of this question. There has not been, nor can there be, a general “exit” from equities and equity vehicles. For every seller of equities there is a buyer. The “rush” to sell must be met by an equivalent rush to buy. Indeed, the aggregate number of shares outstanding in global equities markets has only increased.
On aggregate, the public owns more shares of equities than ever. Thus, the change is not one of the quantity of equity shares owned by the public. The change regards the values at which equities are sold, bought and owned by the public. In other words, valuations have contracted, not the degree of equity ownership per se. Investors are willing to pay less for (or hold) a dollar of earnings per share, cash flow per share and book value per share. This is all a function of a general tendency towards heightened risk aversion. It is reflected in equity risk premiums, implied volatilities and various other measures of perceived risk.
I believe that heightened risk aversion is a secular trend that is likely to continue for the rest of this decade, at least. The extraordinarily high valuations assigned to equities from the mid 1980s through 2008 coincided with the extraordinarily low levels of macroeconomic volatility experienced during an era referred to as “The Great Moderation.” That golden age is over and a historical period of heightened macroeconomic volatility is upon us. This implies a secular tendency for heightened equity/risk premiums and lower stock valuations compared to the era of The Great Moderation. This new world of heightened economic volatility and financial instability will be with us for many years to come while massive global macroeconomic and financial imbalances are corrected.
SA: Do you believe gold is a genuine hedge in uncertain markets?
JK: Over very long periods of time, gold tends to preserve its purchasing power relative to consumer goods. Therefore, over time, the purchasing power of gold measured in consumer goods neither increases nor decreases and tends to mean-revert.
Furthermore, it is not generally understood that the value of gold relative to various investment goods and gross national income per capita doesn't hold up well over time. It is a fact that over long periods of time, holders of gold become poorer than holders of other investment assets.
With these basic facts in mind, it is important for people to understand another factor that currently affects gold’s prospects as a long-term investment. On a purchasing power parity basis, gold is currently extremely over-valued versus just about any asset that can be named – equities, real estate or a basket of goods and services such as the CPI. Therefore, at current prices gold is not a genuine instrument of wealth preservation on a long-term basis. To the contrary, over long periods of time, investors in gold can expect to become poorer on an absolute basis (measured by purchasing power) and significantly impoverished on a relative basis compared to investors in other asset classes (on a net worth basis).
Having said that, on a 1-5 year time horizon, I believe gold will probably make substantially higher highs as a result of heightened fears of inflation. These fears will be triggered by aggressively expansive central bank policies in response to economic crises around the world.
In conclusion, at current prices, gold and gold-related equities such as the SPDR Gold Trust (GLD) may serve as an effective vehicle of short and medium-term speculation on macroeconomic conditions. However, gold and other gold-related instruments are not suitably conceived of as long-term wealth preserving investments.
Global markets
SA: International equities proved volatile for both developed and developing markets over the past 2 years. Do you see a clear winner going forward?
JK: Within major developed nations, the US is emerging as a clear winner. It has the best demographics, the best productivity profile and the most manageable debt dynamics amongst the major developed nations. Despite the massive outperformance of the S&P 500 this past year, I expect the US to continue to outperform versus other developed market indices over the next two decades.
Within emerging markets, I believe that for the first time in many decades, Latin American equities merit serious consideration. Latin America is well positioned to take advantage of the secular bull market in commodities in the next decade. Asia is a major commodity importer and is relatively disadvantaged in this regard. Furthermore, much mal-investment accumulated during the past decade in Asia will tend to weigh down growth. Finally, investment and consumption patterns will need to be rebalanced and currencies will have to be realigned. Thus, contrary to consensus expectations, during the next decade Latin American equities probably deserve a bit more attention than they generally get vis a vis Asian equities.
SA: Where are the real growth stories overseas right now?
JK: The idea of emerging markets 'de-coupling' is fundamentally exaggerated. Emerging market economies are highly vulnerable to the business cycle in developed markets – and they will remain so for many years until their growth models become more based on broad-based internal growth dynamics.
On a risk-adjusted basis, the best way for investors to play global growth over time is through high-quality multi-national companies with diversified exposure to emerging markets. Examples of such companies would be Pepsi (PEP), Procter & Gamble (PG), McDonald's (MCD) and Microsoft (MSFT). However, investors should augment this indirect exposure with well-managed specialized funds so that exposure to emerging markets are at least equally weighted relative to their share in global GDP.
Within emerging markets the best growth stories will be those tied to domestic consumption. There will be a secular tendency for those countries’ growth models to be rebalanced away from exports and towards internally generated growth. The problem is that pure-play emerging market equities that track this theme are limited and tend to be quite pricey at the moment. Specialized funds that emphasize domestic growth stories will be the most appropriate vehicle for most investors to leverage off of this theme. Individual US investors have no competitive advantage in this arena and usually do not even have access to many of these types of companies that tend to be listed on local exchanges.
SA: How do you recommend investors with a long-term horizon, a reasonable risk tolerance and spare cash to play this market? Can you offer some specific funds or names you are recommending at present time?
JK: I have nothing to recommend here at this moment. My recommendation is cash.
SA: When you say ‘cash’, do you recommend investors unload the bulk of their stock and bond positions at present time? What do you recommend individuals that would accrue large gains, and the accompanying tax liabilities, by switching over to cash do?
JK: As you know, financial advice can ultimately only be proffered on an individual basis. Every investor has different considerations that must be taken into account. Having said that, in general, I believe the vast majority of investors would be best served by raising large quantities of cash at the present time. This will lower risk in their portfolios and also enable them to increase their wealth by strategically positioning themselves to acquire larger amounts of productive assets. Furthermore, the reward risk/ratio for equities is extremely low on a 12-month basis.
Regarding tax planning, it is my belief that the vast majority of investors and financial planners tend to grossly overstate the benefits of capital gains tax deferral. First, when you actually perform all of the requisite calculations and scenario analysis, there are very few instances in which the benefit of deferral would exceed the wealth created by selling assets now and repurchasing them twenty percent below their current price. Realistically, you would need to assume that you will continue to hold the entirety of your current portfolio (without ever selling any securities in it) for decades. That is highly unrealistic.
Second, you would also need to believe that capital gains taxes will indefinitely continue to enjoy preferential tax treatment versus ordinary income. Given current economic and political realities, this is a highly questionable assumption in my view. If you factor in at least a 50% probability that capital gains tax rates will rise in the future, then the argument for selling now (and raising cash) becomes even more compelling.
SA: Are China, India or other major Emerging Markets better positioned to withstand a serious global economic downturn than the US?
JK: I do not recommend exposure to emerging markets stocks or bonds at the present time. Emerging markets are not better positioned to withstand a serious global economic slowdown than the US. Quite the contrary. These economies are highly dependent on global growth and global financial flows – both of which may be greatly disrupted in the event of a European crisis. The US economy is relatively autarkic by comparison.
Thus, as long as the global economy and financial systems remain in crisis mode, I do not expect emerging markets indices or related ETFs such as EEM, EWZ, ILF, EWH and FXI to do well relative to US indices and related ETFs such as SPY, DIA and QQQ.
SA: What is the ideal asset allocation for someone with a long-term horizon (greater than a decade) and no need to touch their investments? Can investors continue to rely on stocks after the 'lost decade' we just experienced?
JK: If the time horizon is 20 years or more, a well-diversified portfolio of US and international stocks will outperform bonds, cash or gold. However, for at least the next few months, during this period of extraordinary risk, cash is by far the most attractive asset to own.
Disclosure: No position in any of the securities mentioned in this article. |
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