Lots of people struggle with math. I am married to such a person, which helps me understand. To risk stating the obvious, I am not one of those people. Math always came easily to me, as it does for most people who grow up to be analysts and portfolio managers. Sometimes I need to be reminded that it is not the norm. One such occasion took place last summer.
We hired a 20-year veteran financial advisor and Certified Financial Planner (CFP) away from UBS. As I have explained numerous times this means he had 20 years of experience gathering and managing client relationships, which is what we have hired him to do, and zero experience making investment decisions. We sat him down and began to train him on our investment process and various models. We had barely begun when his eyes glazed over and he asked, “Where did you learn all of that math?”
Investing is almost all about math; specifically, understanding probabilities. For example, what would you say if someone asked you if the current market rally were going to continue? I know, it is our job to provide you with such prognostication, but I would guess most of you have a general feeling about this sort of thing. The market is off to a great start this year and we just had an excellent jobs report showing the economy added 243 thousand jobs in January, far better than expected. I would bet several would say the rally will continue.
What if I asked if you think it is reasonable for the market to be up approximately 70% this year? My guess is most would think that is not very probable with our slow economic growth. The funny thing is that those are actually the same question. If the market continues to go like it has thus far in 2012 it will end the year up 69.2%. I would love it, because in this mythical world our core equity strategy would be up 127.5%, but that is not going to happen.
I hate to be the one to pop the euphoric balloon, but trees don’t grow to the sky and markets don’t go up 70% in a year with 1.5-2.5% GDP growth, shrinking earnings growth, and geo-political uncertainty. We have all those things, and we are on pace for a 70% return; because that logically seems next to impossible, it becomes almost a certainty that we are headed for some sort of correction. It is just math.
The thing about math is that it can tell you what should happen, but it can’t tell you when or how it will happen. We could continue on for another month or two, or tomorrow could be the beginning of the downturn. We could drop dramatically and then rebound, or we may just remain flat for the rest of the year. Timing is an impossible task, which is why we believe it is wiser to be cautious, and to maintain higher than normal cash levels to help smooth the volatility. That is our plan.
Chuck Osborne, CFA