1. The Year of Investing Dangerously

The odds are that a few decades from now, when I’ve retired from the business of managing money—and if I’m still alive—young money managers will ask me, with awe, what it was like to be a professional investor during the Great Financial Markets Meltdown of 2008.

I already know what my answer will be. It was a nightmare—and the ultimate challenge to any investor and any investment strategy, including me and mine. When the first signs of real trouble appeared in 2007, culminating in the collapse of Bear Stearns and its last-ditch purchase by J.P. Morgan, most of us figured that we were experiencing the worst that another economic and market cycle could deliver. This, we all figured, was just another bump in the road of long-term progress. Having lived through the stock market crash of 1987, the recession of the early 1990s, and the dot.com market meltdown, I thought I understood what market turmoil was all about. But then, in the space of only a few months in the second half of 2008, the entire rule book had to be rewritten or just tossed into the garbage. Every tried-and-true tactic failed. Diversification? Forget it—when one market slumped, every other market followed suit, and logic be damned. Even gold, which is supposed to be the most resilient asset of all, the one that everyone flocks to own when they think Armageddon is only hours away, failed to behave as expected. When stock markets plunged and the credit markets entered a deep freeze—at the height of the irrationality—the price of gold plunged 30%. The conviction that downturns were simply opportunities in disguise for the savvy investor vanished almost overnight: Buying on the dips and holding for the recovery didn’t work. There was no recovery; the losses just got larger. No wonder the events of 2008 called into question every iota of conventional wisdom about investing.

Looking back, I suspect that in retrospect we all will see 2008 as an inflection point, after which many professional investors went back to—or were kicked back to—the drawing board. It is now clear to everyone that investing isn’t just about identifying and seizing opportunities to earn the maximum possible return, but also about identifying and avoiding risks that could catastrophically impact portfolios. The conventional wisdom can be wrong—and I don’t think the old rules are going to apply again, or at least not for a long time to come. Going forward, we, along with every other investor out there, will be working in a new environment, one with far more headwinds than tailwinds. However, our most recent experience should not call into question why we invest in the market, but rather it should serve as a lesson that investing is not easy. Investing takes hard work, consistency, and objectivity.

When I’m asked decades from now how I managed to survive the events of 2008 and its aftermath, the answer will be easy: my investment methodology. Indeed, I ended the year feeling particularly fortunate. That might sound strange in the circumstances—after all, the portfolios that we run for clients at Harris Private Bank ended up in the red in 2008, like those of almost every other diversified money manager. (Only 1 of 1,700 or so diversified funds with more than $50 million in assets and at least a 3-year track record managed to post a positive return in 2008: and that fund accomplished the feat only on the last trading day of the year.) Going into 2008, our all-equity strategy had been doing better than a majority of comparably positioned mutual fund managers.

Unfortunately, 2008 turned out to be one of those years that no one could cope with. It was the worst year for stocks since 1931—during the height of the Great Depression—and the fact that our equity-oriented strategies outperformed the S&P 500 that year was, of course, no comfort to anyone because the S&P 500 itself plunged 38.5%. There is no possible consolation for losing that much of your investors’ money. Still, some outperformance was a faint glimmer of hope that we had managed to read the warning signs correctly—although we hadn’t anticipated the sheer magnitude of the downturn—and we had been able to react relatively promptly.

That’s the nature of the world of professional money managers. Despite an awful year for the market, we were confident that we could navigate effectively within our investment policies. Still, at the beginning of 2008, I was worried. Two-thirds of U.S. economists were willing to believe that the United States would manage to avoid a recession that year, according to a January poll by the Wall Street Journal; Wall Street analysts were calling for a 16% jump in corporate profits. My own convictions, formed after “reading the market’s mind” in the shape of the data, disputed conventional wisdom. I believed we were headed for a recession; already, by January, year over year we had seen a 30% plunge in investment in private purchases of residential real estate, only one of many red flags. At best, I figured, companies in the S&P 500 might end up seeing profits fall by 5% in 2008. (As of this writing in early 2009, actual earnings for the year were shaping up to be nearly 20% lower than 2007 levels.)

What all that tells me today is that the more we responded to the signals the market was sending, the greater was our degree of outperformance. We lost less—a great deal less—than we would have if we hadn’t been paying attention to those signals at all. Sure, you can’t eat relative return, as the Wall Street cliché goes, but given a choice between losing nearly 40 percent and a return that was somewhat insulated from that erosion, I know which I would choose. And I am more confident than ever that the data-based strategy I have been developing and using for decades is the methodology best suited to navigating this new, hostile investment environment.

That’s a bold assertion, I realize, especially since I’m writing this in the early months of 2009, with my losses still fresh in my mind and the markets still in turmoil. But the financial markets of the twenty-first century have so far shown themselves to be best navigable by those who are willing to look down at them from 30,000 feet. Those who insist on taking only a bottom-up view have often been caught off guard in the choppy and highly-volatile markets that have characterized the past few years. They’re also trapped in a crowded market; by the end of 2007, according to PerTrac Financial Solutions, there were an astonishing 15,000 single-manager hedge funds and 7,400 funds of hedge funds (funds that invest in a diversified group of hedge funds, hoping to reduce volatility or risk) out there, all looking for the single best market idea—oil services stocks, perhaps, or bleeding-edge biotechnology businesses. Add these folks to the already overcrowded mutual fund arena, throw in the impact of new communication technologies that permit knowledge to zap from one part of the globe to another in nanoseconds, and you’re looking at a hypercompetitive environment.

Add to that the fact that all of us are now struggling to deal with a surreal degree of volatility, which in turn masks the fact that over the past decade most stock indexes have generated no lasting returns. Anyone who put $10,000 into the S&P 500 on January 1, 1998 and reinvested all of their dividends would have seen their portfolio value swell to $12,601 by August 2000, drop to $6,967 by September 2002, and then rebound and surge to a peak value of $14,509 by October 2007. But as of this writing, in early 2009, their $10,000 investment is worth a mere $8,699, an annualized loss of −1.38%.

When markets are that volatile, it’s vital that investors find a way to earn an incremental return over and above what the indexes can deliver, at a reasonable cost, and without taking on much incremental risk. At the same time, trying to outsmart the market, everyone has always told you, is perilous. Unless, that is, you turn everything you know about investing on its head, as I am about to suggest to you in the pages of this book. Unless you learn to read the market’s mind....

Forget about looking only for stock picks and chasing the hot concept of the day. Forget about the argument that you should just buy and hold and never worry about what I call tactical asset allocation and what critics dismissively label “market timing.” Only if you try to approach the entire investment menu, from soup to nuts, and measure the relative risk and return of each item, can you begin to make rational decisions about your investment portfolio, especially in the post-2008 environment. And by being prepared to respond in a timely way to signals that the relative risks and return potential of each of those asset classes and categories have changed, you can generate incremental return. It’s that incremental return, I am convinced, that will spell the difference between outperforming your peers and the market benchmarks and trailing miserably behind.

I have spent much of the past two decades or so developing or refining this methodology, one that is generally referred to in the investment world as a global macro strategy based on “quantitative” models (in other words, relying on the data to tell me which of many global asset classes I should be investing in). Each year, access to data has become simpler, thanks to new technologies and new products. Like all the best investment strategies, it has now become straightforward enough that I felt I could write this book; that I could spell out to you, the reader, how you can apply it to your own portfolios. You can count your net worth in tens of thousands of dollars rather than tens of millions of dollars—and, thanks to the democratizing impact of low-cost investment vehicles such as exchange-traded funds and the Internet communication revolution, any investor inclined to do it himself can use the same investment process that I do sitting in my office in Chicago as a professional money manager.

I believe market selection is far and away the most important investment decision that I can make for my clients and you can make on your own behalf. Numerous studies have shown that the markets in which you have exposure, whether they are stocks, bonds, real estate, or commodities, explain the overwhelming majority of how you ultimately achieve your investment return. Therefore, asset allocation, both long term and opportunistic, is paramount in developing an investment portfolio. However, once proper market allocations are determined, investors must then decide how best to gain exposure to those markets. There is a panoply of possible courses of action. Whether you employ exchange-traded funds, mutual funds, or individual security selection to flesh out their investment portfolios is up to you. The key to a successful portfolio is the underlying skeleton that’s both structurally sound and flexible. The global macro process laid out in this book will help you construct and maintain that foundation. It’s also as simple to use as if you were driving a car and keeping an eye on the dashboard while still looking out the window and monitoring what is going on in your rear-view mirror. If you can successfully navigate the traffic on an interstate, adjusting to changes in speed of traffic around you, what your fuel gauge is telling you and the behavior of the lunatic driver of a tractor-trailer in the next lane, you can navigate the financial markets using the series of quantitative tools, or factors, that I outline for you here.

We live in challenging times, and even more now than when I started working on this book in 2007. Soaring energy costs have crippled the airline and automobile industries as well as giant chemical producers like DuPont. (True, oil prices, as I write this, are well below their June 2008 peak of $148 a barrel, but they are also still well above their 2000 level of $28 a barrel.) Government regulations cost companies still more; Sarbanes-Oxley alone, put in place to combat corporate malfeasance of the kind that destroyed Enron and WorldCom, their employees, and shareholders, costs the average U.S. company $2 million a year to comply with. Hedge funds, already dumping their holdings into the stock market as they slash the amount of leverage on their balance sheets, are likely to be a target of new regulations, as are financial institutions. (My point isn’t that regulation is a bad idea, but rather that “good” and “bad” regulations alike carry with them costs, and those costs eat into corporate profits and, ultimately, into investment returns.) Above all, despite talk of a “peace dividend” in the 1990s in the wake of the collapse of the Berlin Wall and then the Soviet Union, we’re back in a period of intense geopolitical conflict. The September 11 terrorist attacks ignited a costly “war on terror” by the United States and its allies, and two wars in Afghanistan and Iraq are draining billions of dollars from our government’s coffers every month. Defending the nation is necessary, but it’s also proving to be very costly; meanwhile, the geopolitical turmoil simply exacerbates the volatility of financial markets.

I’m not trying to tell our nation’s policy makers what they should do next. My job is to find ways to outperform financial markets at a time when that task has been made more complex by what the policy makers are up to—and what they may do in the coming years. Like poker players (at least, like honest poker players who don’t cheat), investors have no control whatsoever over what cards we are dealt. All we can do is make the most of whatever hand we are given. In poker, it’s possible for a skilled player with an inferior hand to outwit and thus outplay someone with three kings. In investing, your odds of generating respectable incremental returns even in the most oppressive investment environment are better if you play your cards right.

Whether you’re an individual investor or a pro, there are a myriad of ways to manage money; from buy and hold to point and click. Regardless of your approach, my mission in writing this book is to help individual investors gain a foothold in a fiercely competitive investment marketplace. If you’re an experienced player, I’m hopeful that you’ll be able to incorporate my process into your investment decision making. If you’re new to the investment world, perhaps these steps will help you develop your own style. My own approach to doing this is not a get-rich-quick scheme. In fact, I hope that one of the reasons that you picked up this book is that you are just as sick of all those ridiculous and unrealistic promises of effortless ways to earn fabulous wealth as I am. To successfully outperform the market over the long term (not just overnight), you need to learn how to read the market’s mind, to figure out where the risks and rewards are most acute at any given point in time. I’ll introduce you to a set of metrics that will help you do just that. Some may be familiar—the price/earnings ratio, for instance, is a classic valuation technique. Others are likely to be more novel, such as the key role that monitoring the 200-day moving average of any market’s index can play in your decision to jump in or out, pocketing profits and dodging dangers. Collectively, they represent a set of investment decision-making tools that you can use in whatever way you see fit, aggressively or defensively, depending on your own goals, liquidity needs, and risk tolerance. Each tool on its own is not an investment panacea, yet taken collectively, they provide a valuable mosaic of the investment landscape.

In my role as chief investment officer at Harris Private Bank, my team and I use the model and the tools I describe in this book every day of the week. We scrutinize each of the data points that I suggest you heed, and we put them into our investment dashboard, adjusting our direction, speed, and so on in response to the signals they send. How I drive the car when I’m the only passenger, how I drive it when it is full of a whole bunch of passengers all with different tolerances for speed, and how you will choose to drive it are all very different matters. In my role at Harris, I’m responsible for a busload of passengers, all of whom are very different and have different needs and objectives. Harris Private Bank, a division of Harris NA, has thousands of clients representing individuals and families with needs and objectives as varied as the families themselves. So, my ability to respond to the signals on my investment dashboard is determined to some extent by the fact that an aggressive response, although it might be perfectly acceptable to a handful of my clients who have specifically spelled out their investment desires, may be much too risky for many others. That’s the essence of what is required of a professional investment manager devising model portfolios for clients based upon their individual risk tolerance; like my peers, I’m what is called a “trusted advisor.” That’s why our clients each have their own portfolio manager, an investment professional who customizes a strategy to serve their specific investment needs. When I refer to “my clients” or “Harris clients,” I’m speaking in general terms and I do not intend to describe all our clients collectively. Within a broader investment process at Harris, my team and I serve as a critical resource for our portfolio managers. Those men and women, armed with their own impressive resumes, take the information our team supplies and, considering their clients’ needs and proclivities, construct tailored portfolios. A triple-weight in emerging market equities can be great when the market is surging, but it’s not for everyone. As long as you are honest with yourself about your own needs, goals, and risk tolerance, you can employ these tools any way you want. You can be as aggressive as the most ferocious hedge fund manager, responding to the data signals about markets that you receive by shorting some markets and buying call options on other securities. Or you can use the same tools in the most conservative portfolio, to tell you when it’s time to move another 2% of your cash holdings back into stocks. Regardless of the way you choose to use this information, it will help you make more confident decisions.

We may not encounter the outsize volatility and horrific investment losses that characterized 2008 for another decade or longer. But in the investment environment we must navigate in the wake of that agonizing market climate, all of us need to be able to respond to market signals as accurately and rapidly as possible to capture each smidgen of investment income we can find. In the pages that follow, I show you exactly how to do so—and how to avoid the traps that can eat into that return.