No End In Sight meets Mr. Alpha and Regression to the Mean

“U.S. bank stocks may be staging another suckers' rally.”
Reuters, July 31, 2008

From time immemorial the four most dangerous words in the investment language has been “This time is different”. Today, however, a new phrase seems destined to join the dreaded phrase group – “No end in sight”.


If an investor assumes that the IMF is correct, then the bank loss write-downs could reach $945 billion. If hedge fund investor extraordinaire John Paulson is correct, the number increases to $1.3 trillion. If Bridgewater Associates is correct, the number rises further to $1.6 trillion. And the top end of Nouriel Roubini’s disaster scenario range is a cool $2 trillion.

At under $500 billion in losses taken thus far, “no end in sight” is an apt phrase.

But, to quote the Joker, “Why so serious?”

Investment Strategy Implications

While the relief certain investors may feel due to Merrill’s actions may be premature, investment strategy considerations drive the current portfolio decision-making process. For, if an investor has been fortunate enough to have produced alpha thus far this year – for example, portfolio and investment strategy decisions made in the Model Growth Portfolio (MGP) have yielded over 300 basis points of alpha thus far this year – then the real risk may not be the next plunge in equities (that’s coming) but the danger in not exploiting the near-term momentum game courtesy hedge fund momentum players and thereby losing valuable alpha in any short-term bear market rally.

Therefore, the appropriate current investment strategy appears to be largely a market neutral one. With an undervalued market and no sustainable and exploitable trends or themes at work, being fully invested – yet with no particular tilt from a sector perspective* – seems most appropriate. It’s only from a style and size perspective that a modest tilt toward the Smids and growth (as opposed to value) remains advisable**.

So, when Warren Buffett declares that the financial crisis due to “financial weapons of mass destruction” is “far from over”, investors should heed the warning. For those who are paid to exploit near term market moves, however, an undervalued market dominated by hedge fund momentum players is too hard to ignore and an investor stands to lose a considerable amount of hard won alpha***.

No end in sight is real. However, regression to the mean in an undervalued market may take precedence for the time being.

*The MGP is strongly underweight Energy. This will change shortly pending their 2Q08 earnings reports, the potential of negative political influences therefrom, and technical analysis considerations.

**This, however, would change should the recent weak relative performance of the Smid growth styles continue.

***If wrong, then the absolute performance will suffer, no doubt, but the alpha remains largely unchanged.