By: Ronald D. Struck                                                            December 1991

IT'S TIME TO GET DEFENSIVE

So, here we are again.  In a very nice rally which has run since the beginning of the year.  Long Treasury bonds have seen trades through 8% yields and the 3-month Treasuries through 5%.  It is time for portfolio managers to start getting defensive with their position and the winter of 1991/1992 will offer an excellent opportunity to do so.

There are two types of portfolio managers - Realists and Unrealists.  An Unrealist's portfolio is usually doing fabulously or is in the tank and here's why.  When bonds are rallying and profits come easily to almost everyone, regardless of capabilities, Unrealists let their egos get the best of them.  They develop a false sense of brilliance and become overly optimistic.  They think they know their markets like no one else.  Because most assets are increasing in value, they think they are doing an outstanding job managing them and this trend will continue unabated.  They become almost euphoric, thinking that the only limit on their profitability is the size of their portfolio.

But rallies always end.  The value of securities declines making profits and net worth extremely difficult to maintain.  Even though the Unrealists did not utilize opportunities available during the rally to protect themselves, they accept little if any responsibility for their plight.  They blame overall economic conditions, the government and other such things, which they quickly point out are beyond their control.  Because they did not take the defensive actions available to them during the rally, the only strategy left available to them is to ride out the down cycle, hoping that they have enough staying power to still be around when the next rally begins.

But what about the investors who continue doing well during the downturn in bond prices, using it as an opportunity to make investments at much more attractive levels.  Unrealists say they are just lucky but I say most of them make their own luck because they are "Realists.”

A Realist understands the basic rule of successful investing, to buy low and sell high.  But they also understand that to attempt to buy at the absolute lowest point and sell at the absolute highest point is an impossible objective.  Economic cycles move back and forth from highs to lows, albeit with no regularity and seldom on the same path.  Realists recognize that a realistic objective is to attempt to anticipate general shifts in the direction of cycles, buying in cycles when bond prices are relatively low and selling when they are relatively high.

The current cycle in prices for fixed income securities is well into a major upswing.  Each day prices hold at their current levels or improve the probability for a change to a downswing grows stronger.  The risks of a potential upswing, causing yields to increase and bond prices to fall, over the next 6 to 12 months are substantially greater than a continuing downtrend.  Therefore, this winter will prove to be an unusually attractive opportunity to restructure portfolios into more defensive postures.

So, what do we need for rates to continue to decline and prices to increase?

In Economics 101, we learned that when demand exceeds supply, everything else being equal, prices increase.  Throughout the world, the demand for capital from government entities, corporations, and individuals far exceeds available supply.  However, the prices for capital (interest rates) are falling.  A defense for this decline is that real rates (interest rates minus inflation rates) are very high.  There are two problems with this defense.

Real rates of return float with changes in the inflation rate therefore they are subject to change quickly and substantially.  If you lend your capital to achieve a real rate of return, the rate of inflation will have to average your targeted level on a duration-adjusted basis equal to the bond. 

Second, if low inflation rates are the cause for the attractive real rates of return being generated, perhaps a better long-term use of capital would be to invest in hard assets.

Regarding the inflation rate, for prices to rise moderately or even decline I believe a necessary ingredient is relatively (not completely) stable conditions in the world, just as existed from 1929 to 1939 during the Great Depression.  We are in a post-cold war period.  Are we entering an era of economic and political instability like that which existed in 1918 after WWI, when protectionism, growth, and price increases lead to the crash of 1929.  Or are we entering an era of relative stability like that which existed in 1945 after WWII in which there has been no major market crash (unless we're in it now).  I believe the world had MORE stability prior to the developments of 1990 and 1991.  The USSR could control and direct most of the activities of Eastern Europe.  Now it is every republic for itself.

Top