Category 5 Asset Inflation

matt

We finally made it home yesterday. Thankfully the eye of the storm stayed slightly off the coast. I took the above picture Friday morning while working from one of my many satellite offices (another Starbucks). It doesn’t get much closer than that! It was a miracle the eye stayed off the coast of Florida. We were very fortunate.

For three days I watched a category 4 hurricane move closer and closer to our house. It was very hard to concentrate on anything else. For the first time in a very long time, I had trouble paying attention to the companies I follow and the financial markets. However, I did watch a lot of The Weather Channel. Now that the storm has passed, I plan to avoid The Weather Channel for the foreseeable future. They should change their name to The Weather Stress. Want a cure for being relaxed? Watch The Weather Channel for three consecutive days. Although their sense of urgency can be a bit extreme at times, I suppose they are helping reduce complacency.

Another benefit of watching The Weather Channel, is they provide helpful hints on how to survive a hurricane. As the storm approached, hurricane survival tips were reviewed frequently. Considering I was interested in surviving, I listened closely. Here are some of the things they recommended: a flashlight, water, first aid kit, blankets, batteries, food, and medicine. Check, check, and check – I was prepared! But wait a minute, I didn’t feel prepared. I still felt uneasy. Will these items really help me survive a category 4 hurricane? In the end, either the storm hits or it doesn’t. No matter how many cases of bottled water I accumulated, the hurricane checklist didn’t seem sufficient.

The hurricane checklist reminded me of other risk management lists that provide people with a false sense of security, including those related to investing. According to conventional wisdom, one of the most important items investors should have on their risk management checklist is diversification.

By diversifying, investors attempt to reduce risk by spreading capital over many securities and asset classes. But what if after eight years of extremely easy monetary policy and significant asset inflation, all asset classes are overvalued? Then what? Do you buy the least overvalued? Is that adding value? Maybe in the relative return world, but for absolute return investors, overpaying is overpaying – it’s a value destroyer.

As I’ve stated several times in past posts, my opportunity set is currently extremely expensive and carries above average risk. Assuming I allocated capital to purchase small cap stocks today, I’m confident I would not achieve my absolute return goal of generating adequate returns relative to risk assumed. In fact, at 2x sales and 26x earnings (closer to peak earnings), my possible buy list currently trades at valuations that would cause considerable losses if valuations normalized. The elevated risk of large losses and lack of value within my opportunity set were the main reasons I moved to 100% cash.

While I think my opportunity set is poor, I believe professional capital allocators who are required to invest in a variety of asset classes have it worse. How are they supposed to achieve their long-term 7-8% absolute return goals given the inflated prices within their opportunity set? Should they buy domestic stocks? The data doesn’t support it. Valuations, especially median measures, are near or above record levels. Should they buy bonds? Is it even necessary to ask this question? Should they buy real estate? See bonds. How about private equity and venture capital funds? Sure, if they want to own what their competitors are flocking into in order to goose their efficient frontiers (I could do an entire post on the pitfalls of efficient frontier investing). And then there’s cash yielding 0%. This would be my choice, but considering 0% doesn’t look so hot on an efficient frontier, good luck recommending patience during the next board meeting.

In my opinion, in an environment when most asset classes are overvalued, diversification is an inadequate method of risk management. In a period of expensive valuations and broadly dispersed asset inflation, relying on diversification to protect capital feels a lot like collecting bottled water and batteries in front of a monster hurricane. Instead of depending on diversification and waiting in long lines with other investors, I’ll stick to my plan of sitting out the approaching storm by refusing to overpay and remaining patient. When it comes to hurricanes or inflated asset prices, why risk so much for so little?