In the classic movie, The Wizard of Oz, there is the memorable scene that has the wizard being revealed as the small little man that he is. By this time though, Dorothy et. al. have gone through enough trials to have confidence in dealing with a “bully” as it were. The quote that I’m referencing is, “pay no attention to the man that’s behind the curtain”. And although I rarely do this, I’m going to give you the punchline of this blog right up front. Resist the urge to try to keep up with the markets. There you have it. I am proverbially “dropping the mic”, and exiting stage left. (For those of you that want just a little more, read on.)

As a veteran of the industry, I feel I should justify my position. After all, I ran a municipal trading desk for nearly five years and booked annualized returns of 7%, so I’m not talking out the side of my face. For years though, I felt the elixir that the financial markets was drinking seemed too good to be true.  And regardless of my gloating a few sentences ago, I realized then (and am acutely aware of now) that I was not the smartest guy in the room, so I often spent time asking [a lot of] questions of a lot of people. The majority of them echoed the same sentiment…”things are weird out there”. They meant in both the bond and equity markets. (I realize there are more asset classes than just those two, but they cover most of what retail investors have to choose from.) So that led me to evaluate what was so weird….

# 1 Weird thing…Equity markets have gone up [way] more than corporate profits.

So you might say, Dominique, this will always happen because investors look at P/E ratios and are essentially willing to pay for earnings that have yet to happen. But let me warn you, there’s a reason that “past performance is no guarantee of future results”.  So here are some facts for you.  Per the Shiller PE ratio, the market trades at an average 16x multiple, although it is currently at 27x.  Also, understand that on average, and a fairly recent average (e.g. 1984-2014), equity markets returned 10%.  So here comes the weird…I began to realize that nearly every investor, especially those with most of their investable net worth in company retirement plans: a) rarely has the option of building a fully diversified portfolio (more on that later), or b) has the discipline to stick with an investment strategy for more than one market cycle. So let me address two major issues that I just ran past. The first is that the market by nearly any estimation is overpriced as it relates to actual corporate earnings.  Next, is the lack of “real” choice in 401(k) plans combined with investor psychology. I’ve written previously on corporate profits and market valuations here, but the refresher course is that corporate profits have actually appreciated about 38% (since about July 2008, whereas equity markets [measured by the S&P 500] have appreciated about 87%.  Could it be that 401(k) deposits are pushing the market higher instead of corporate earnings? Quite possibly.  This wide variance can also be attributed to the result of a lot of stock buybacks by corporations due to the relatively inexpensive carry trade. Corporations have used the low-interest rate environment as an opportunity to issue debt at phenomenally low rates and use the tax shield provided by the interest deduction to lower their tax rates. This concoction allows company XYZ to raise a lot of cheap funds by issuing bonds while using the cash to buy their stock.  More buyers of stock, raises the price and begins to inflate valuations. Next point. Defined contribution retirement plans force most participants into a “long-only” [mostly equity] position regardless of their risk tolerance and time horizon with a menu of 10-15 funds (and I’m being generous). I’ve looked through several 401(k) plans and have been left scratching my head at the dilemma for plan participants.  And if after you finally decide on an allocation, then you get to read and hear all the “doom and gloom” of BREXIT, China’s economic implosion, Japanese helicopter money and the like.  The majority of investors are thrown into a panic in which they end up selling too low and buying back in too high. This is the reason that while the S&P 500 averaged 10% from 1984-2014, the average investor only made 3%.

#2 Weird thing…Short interest is high in equities and bonds.  

The smart money (as it is sometimes called) has seen the trends I’ve named above for years now and have promptly taken the other side of the trade.  So if not smart, definitely enterprising.  As Mr. Ray Dalio says, “if you’re at the poker table wondering who the sucker is, then it’s probably you”.  This crass use of Ray’s words will hopefully help me bring home a point I intend as a gut punch to all individual investors reading this blog right now.  There is a grand fallacy in trying to beat the market. Between all the computer programs that trade markets in hundredths of a second, and the mountain of institutional cash out there with access to up-to-date information, the average investor is up to an insurmountable task in trying to beat market returns. The collective market is hard to beat.  Then, why should you?  Before I answer that…I was saying, the smart money has taken the other side of the trade and sold short a lot of what the average investor might be buying in the company 401(k). Sorry if this was a big secret to you, but it is happening. I recently was reading that this year has only seen 5 weeks of positive equity fund flows, but yet the market is up 6% as of this writing. Well how is the market still going up in the face of so much selling? This is when it helps to realize that the buying that is taking place is actually the covering of short positions. How much short covering? A lot.

So what does all this mean? It means that trading in your 401(k)—regardless of how large it is—is up against a huge wall of money going the opposite way “in trend”. Which means that if you try to keep up with beating the market you might wind up feeling like the carpet has been pulled from beneath you before long. This necessitates you looking at your investment strategy totally different and with a disciplined perspective—not a in and out mentality.

#3 Weird thing……Low interest rates.

Now, low-interest rates are not exclusively weird since there has been precedent. Also, easy money policy or low-interest rate policy (“LIRP”) serves to induce spending to stimulate an economy and keep it from deflation. Trust me, when choosing between deflation or inflation you want inflation—see Japan. So, my point is that this is not a discussion on whether or not interest rates are artificially low (they are) or that the government is printing too much money (who cares). I want you to take a look at the macro picture which I feel is really the only thing that matters.  Think of the US Central Bank’s current monetary policy as potentially disruptive to global economic growth, since many countries are still attempting to recover from the 2007-2008 financial crisis. Most economies abroad are still having problems growing GDP (as are we). Let me back into the explanation….a country can’t raise its interest rates as long as growth is stalling. So instead, they lower interest rates to induce spending (and spur growth).  But what can happen as a result? First, your currency can depreciate which is not all bad because it can give you a competitive advantage with [relatively] cheaper goods to sell.  However, there are other ramifications to consider.  Alternatively (or co-currently), lower interest rates can drive investment capital offshore to higher interest rate economies.  Since capital generally seeks the highest return, this has been seen in some emerging economies.  This can dovetail into eroding the competitive edge gained by currency depreciation and cheaper goods.  The eroding effect happens when the foreign capital headed for “greener pastures” is due to be paid back in a devalued currency.  Quite literally, the cheap currency has bought an advantage that they can’t capitalize on because the interest and principal due on the foreign loans is much more than what was borrowed.  Ideally, a depreciated currency would have stimulated enough economic activity for the foreign capital to remain in the economy.

The fallacy of chasing market returns graphic

However, other factors in an interdependent global economy don’t allow for the ideal all the time.  A recent example of this was the commodity panic in 2015 on the back of lower oil prices.  Only the strongest of emerging economies have survived the revaluation of their currencies.This is what I feel is the most alarming about global economics and another reason why I maintain that the US is still the “cleanest dirty shirt”.

So what do I suggest? Well, that will have to be saved for part 2 because after nearly 2 decades in the industry I feel there is a way to overcome this market weirdness, but it has nothing to do with trying to beat the market.

(TO BE CONTINUED)