We like to use a sailing analogy at Atlantic Advisors to describe our process. Imagine you were sailing across a bay to have dinner at a lovely restaurant on the other side. Under the traditional investing approach, you would consult the Farmer’s Almanac4 and decide which way the wind should be blowing, the speed of the expected wind, and the direction and speed of the currents which should prevail at this time of year. With this long range information, you could confidently get into your sailboat and set the sails and the rudder for this information, and simply go below deck for a while until you arrived.

It seems absurd, but this is exactly what we’re doing with asset allocation and expected returns. In reality, if you want to get to that restaurant you may begin with some historical observation just to set your expectations, but as you set out from the pier you would stay on deck, sense the change in the environment, and make appropriate adjustments in order to make it to dinner on the other side.

The most important part here is making it to dinner safely (the goal), instead of the angle of the sails and rudder (the investment process). 60% Equity/40% Bonds is not a goal, it is a static process that doesn’t allow for adjustments in pursuit of the real goal.

For too long, investors using the traditional approach have become “return takers.” The asset allocation multiplied by the market returns, gives you the outcome. In any particular year, you get whatever you get, and we just hope you like it. This has become blindly accepted. But realizing that you can make changes in the portfolio in pursuit of your real goal is a revelation of real power to the investor. No longer do they feel held hostage to the market, they can now stipulate what they want to achieve.

Armed with the power to set specific goals, then the investment process can begin.

Understand the Big Picture

Most advisors and consultants preach against this. It‘s been pejoratively labeled “market timing” or “forecasting”; skeptics say that, since “nobody knows what’s going to happen.” There’s no point in even trying. Just keep rebalancing, and it will all work out in the long run.

Hmm... How’s that been going for the last 15 years? How long should I persist in this costly experiment? A recent study showed that the average corporate pension plan was 120% funded at the end of 1998. By the end of 2008, the average pension plan was down to 65% funded. Should we keep pursuing this “invest for the long run” at all costs?

At the heart of investing, we’re taking a pile of money which our clients have worked hard to earn, and we are investing it into the world. How could we possibly fulfill our fiduciary duty by simply looking backward and investing based on the average of the last 20/30/50/100 years? Is this really what the Prudent Man Rule was suggesting?

Or are there some basic guideposts which allow us to understand where we are, and signal high risk and low risk entry points into the market? It is clear looking backward that there are cycles in the market that happen through long time periods. From the seasonal factors that affect the market, to the four year presidential cycles and all the way out to the 15-20 year secular trends, we see cycles.

Asset allocation focuses on expected returns5. For equities, 10% is a common expected return for the long run. But equity is nothing more than ownership in a company, which conveys a right to receive the residual value of the enterprise. So we know right away that what we pay for the company will have a direct impact on the return that we receive in the future. This metric is referred to as the Price/Earning (P/E) ratio, which varies greatly over time and can achieve significantly high and low values.

If we pay a high P/E ratio for our stocks, we shouldn’t expect to earn a 10% return over the long run. But if we can buy them at discounted levels, we can actually expect to earn returns greater than 10%. These valuation cycles are long term in nature, and simply saving our risk dollars for times when P/E ratios are low rather than high can add significantly to our returns over the long run.

Similarly, yields on fixed income can be viewed through the lens of time for high risk and low risk entry points. Since 1981, bonds have been on a steady decline in yields, and increase in price. In October of 1981, the 30 year US Treasury bond was yielding approximately 15%. And since that time, we’ve been in a steady decline of yields all the way to the low of 2.53% in December of 2008.

It’s very hard to “time the market” and catch the highs and lows. But we know that at 2.53%, rates can’t go much lower, but they could go a lot higher, especially when we consider the massive new bond issuance that is beginning today and going on for the foreseeable future as we attempt to get out of a debt bubble by borrowing even more (and how does this make sense?).

Without trying to time the market, we’re sensing the environment of wind and tide, of valuation and yields, and of sentiment and money flow. And without regard for market benchmarks, these senses of the current environment are then applied in the context of the clients’ goals. My firm is always looking forward in time in order to achieve our clients’ goals. How could we discharge our fiduciary duty in any other way?