"Well, I agree with you that everything is expensive; stocks, Treasuries and even junk. But remember, there are two sides to every trade.
"In the days of the great bull market, if you thought prices were getting ahead of themselves you might take a breather, take some profits and wait for a dip to get back in, like 1984 and 1987. But you were always long. Today, on the other hand, when everything is so expensive, it could take years to get back down to normal valuations ... Or, you gotta agree it's possible, a correction could happen suddenly. I don't know about your clients, but half of mine are retired and making withdrawals from their portfolios. If I try to hide from the overvaluation of stocks and bonds, what am I going to earn hunkered down in cash and short-term bonds? 1%? 3%? That's not enough; I have to shoot for 7% average returns. If I don't believe that being long in the market can provide that, I have to think, 'How can I make money even if the market is choppy, flat or falling?'"
"Whoa, brother!" a frightening realization had apparently fallen upon Bob. "Are you talking about selling short? Naw, you're not; right? Tell me you're not."
"The idea is as foreign to me as it is to you, Bob. I'm just thinking out loud about ways we make might make money for our clients in the capital markets when we don't have the wind to our backs like we did when P/Es were rising and interest rates were falling.
"The most fundamental rule of portfolio management keeps coming back to me: DIVERSIFY. We all agree you never bet the farm on any one concept, right?" Bob nodded but his arms were folded across his chest and his face was a mask of skepticism. "That used to mean you put 60% or 70% in a basket of small-cap, large-cap and foreign stocks, something like that, and you mixed in 30% or 40% of short-to-medium-term bonds to dampen volatility, right? That was diversified.
"But we both know that stock returns in the U.S. and Euroland are no longer uncorrelated. In both places we're looking at historically high valuations, sluggish demographics and high debt loads that strongly imply slow growth and at least the risk of a financial disaster of some kind. And the gap between value and growth stocks has largely closed; ditto for small- and large-caps. So if we have 70% of our money in developed market stocks, are we diversified or have we bet the farm on a single delusion?
"I have to wonder, just wonder mind you, if perhaps I should consider making an investment in the possibility that valuations will come down to match the slower-growth realities of the mature economies. It would certainly provide some diversification, right? And it would give me a vehicle for rebalancing. In the last ten years, I used long-term Treasuries for this purpose, but that game seems largely played out."
The Next Wave
"Would you short stocks, or what?" "No, not individual stocks; but I could go long the Rydex Ursa fund, or maybe buy index put options. I haven't gotten that far yet. But a long market slide would not be a surprise, so that's one possible wave I'd like to be prepared to ride." "What are some other waves?" Bob asked.
"Well, the Fed and most other central banks seem increasingly locked into what looks to me like a currency war. Every host country wants its currency to be cheaper than the other guy's to help their trade balance. But obviously this is a zero-sum game. If the game goes on, it seems pretty obvious that the price of globally traded raw materials like energy, metals and maybe food will rise in currency terms. There's a wave we could ride. It would help offset damage to the principal value of our fixed-income portfolios. It would be like overweighting energy and mining equipment in the 1970s."