A Counterintuitive Approach
As markets reach stages of euphoria and valuations get stretched beyond any historic or normal metric, it’s often useful to consider a counterintuitive approach to asset allocation. While we think this bull market still has legs given the profound levels of liquidity being injected into the system, we are also keeping one eye cocked for what could go wrong. The bullish herd mentality is at one of its highest points we have witnessed in our careers, and this is where investment decisions (and the perspective from which they are made) become critical.
Consider the image below:
During World War II, the British air force was seeing a tremendous number of planes lost due to anti-aircraft fire so they decided to add armor to the planes. The question was where to put the armor? Consensus among the highly experienced team of aeronautical engineers examining the planes returning from missions was to map all the bullet holes in various places, and then add additional armor in the areas that attracted the most fire.
This approach seemed obvious, exactly like the bull market we are bound to have this year given the unprecedented amount of liquidity being thrown into the system. But maybe not so obvious. A contrarian came along, Hungarian-born mathematician Abraham Wald, who explained that if a plane makes it back safely even though it has, say, a bunch of bullet holes in its wings, it means that bullet holes in the wings aren’t very dangerous. What you really want to do is armor up the areas that, on average, don’t have any bullet holes. Why? Because planes with bullet holes in those places never made it back. The planes that did return had not been hit in the critical spots.
The question for us today, at a time when the consensus of highly experienced market engineers is so bullish, is how to best armor our portfolios. While traditional investment grade bonds have been the best defensive shield in the past, we are staring at flat to negative returns over the next five years. We are therefore expanding into other areas of fixed income like private credit, where we see a much more favorable risk-reward. Gold is clearly a defensive tool that provides protection against both inflation and geopolitical crisis. Dividend paying value stocks have underperformed for 10 years but are starting to look attractive from a valuation and income perspective. And finally, we believe the market will continue to pay a premium for growth, so finding companies that are taking advantage of the shift toward the new economy will continue to be a major focus for our team—we just want to buy at a reasonable price.
Diversification has never been more important than now, given global economic dislocation and rapid movement of capital. A narrow portfolio might soar during the market’s next sugar-high phase but without proper armor could suffer when malaise or unintended consequences of the unprecedented spike in liquidity start to show themselves.
Please let me know if you have any questions via phone at 804-774-2087 or email at Jesse.Ellington@middleburgfinancial.com.
Disclosures:
Past performance quoted is past performance and is not a guarantee of future results. Portfolio diversification does not guarantee investment returns and does not eliminate the risk of loss. The opinions and estimates put forth constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.