Newsletter – September / October 2010 – Dinosaurs Leave Tracks


Dinosaurs Leave Tracks

When we talk about investing, we usually think of the stock market. But when modern portfolio management text books were being written in the 1950s, they recognized several different classes of investments: equities, bonds, cash, precious metals, real estate, commodities, and currencies. But today, we think investing is mostly about the stock market.

And that’s the problem. 

Let’s try to think more like big pension fund managers. They try to hold large amounts of investment classes that are the top performers and only small amounts of the underperforming classes.

In June 2010, the investment manager Gluskin Sheff released their calculations of the 10-year rates of return of a variety of US investment classes. The return for the US stock market was -2.3%. Big American pension plans have lost 2.3% per year in the stock market over the past ten years.

The ten year returns for US bond portfolios have been +11%.

Based on the math, it’s clear that the big US pension funds should be heavily invested in the US bond market and only slightly invested in the stock market. It’s called efficient market theory and it’s simple and logical.

If it’s so simple and so logical, why are US pensions over 50% invested in the stock market? And why do they hold under 7% in bonds? They have it exactly backwards! Why are stocks their biggest asset class and bonds one of their smallest? How could they make such a monstrous mistake?

Most of their portfolios are invested in stocks that gave them a -2.3% return for 10 years. They will correct this glaring mistake by methodically re-balancing their portfolios until most of their money is in the better performing investment class (bonds), and the least of their money is in the poorest performing investments (stocks). In other words, US pension funds will be collectively selling billions of dollars of stocks and buying billions of dollars of bonds. Because of the huge size of these positions, it will take years to complete this adjustment. We refer to this giant inventory of under-performing stocks as the overhang. The US stock market will be “over-hung” for years. Until American pension funds work off this overhang there won’t be a long term bull market in US stocks.

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