Diversifying in the everything bubble

Posted By Darren Winters on Sep 6, 2019

Diversifying in the everything bubble

Diversifying in the everything bubble is like trying to square a circle.

Money manager will go the extra mile to engineer diversification in their portfolio because forecasting is a dicey business.

My understanding of a well-diversified, hedged portfolio is one invested in a wide range of assets where those assets prices are inversely, or negatively correlated to each other.

So when one asset falls in any given day the other asset rises, in theory.

For example, if there is a crash in risk-on assets, such as stocks, commodities, and emerging markets, then capital flows into safe-haven assets at the speed of a loose cannon on a ship’s deck.

So it’s better to start building a portfolio positioned for the storm while the weather is relatively good, after all, who wants to mend a leaking roof during a storm?

Moreover, safe-haven can be bought at a bargain when everyone is on the other side of the boat in risk assets.

Diversifying in the everything bubble is tricky

The relationship between bonds and stocks illustrates the above.

Stocks and bond prices tend to move in the opposite direction. So when stocks rally bond price fall and their corresponding yields rise.

Diversifying in the everything bubble is difficult because of this uncorrelated relationships between the price of various asset classes have broken down, or ceases to exist

Diversifying in the everything bubble

Stocks and fixed income assets (bonds) are already so financialised. Evidence of this is that both assets have been rising in tandem, which doesn’t usually occur during normal market conditions.

But these are far from normal times. For more than a decade, the Fed and its western aligned sidekicks the ECB, BoJ, BoE have coordinated the largest monetary experiment in the history of finance, which entailed 21 trillion dollars of coordinated asset purchases, known as quantitative easing QE.

Consequently, bond yields are near record lows, bearing in mind that the price of bonds and its corresponding yields move in the opposite direction.

Already the amount of global debt with negative yields has ballooned to $15 trillion.

Negative bond yields and negative interest rate policy are like maggots feeding on a decaying financial system.

Diversifying in the everything bubble has been made almost impossible with monetary policy lunacy, which guarantees that conservative investors will lose money

NIRP will not add liquidity to the system it will do the reverse, it will trigger bank runs, after all which rationale investor will leave funds in a bank deposit only to be charged for doing so.

Why would an investor buy sovereign debt even with the highest credit rating if it offers negative yields? In other words, investors would be lending money to the government long term and end up getting less back.

Put simply, diversifying in the everything bubble is a conundrum because safe-haven assets, such as the safest government bonds AAA ratings are also in a bubble, as they offer investors negative yields.

Diversifying in the everything bubble is difficult as risk-on assets are also in a bubble

Standard & Poor’s stock index is trading near its historic high price earning ratio P/E10 ratio is at 30.0. The trailing twelve months (TTM) price earning ration TTM P/E ratio is at 22.0.

There is a correlation between stocks and their cyclically adjusted price-earnings ratio which is abbreviated to P/E10.

The historic P/E10 average is 16.9. After dropping to 13.3 in March 2009, the ratio rebounded to a high of 23.5 in February of 2011 and then hovered in the 20-to-21 range. It began rising again in late 2013 and is currently at 30.0.

So by the P/E10 ratio matrix, which is a preferred method used by the greatest value investor Warren Buffett to gauge stock prices, stocks are also in a bubble.

Diversifying in the everything bubble, the real estate bubble is no answer either.

Easy money has fueled a high-end real estate bubble.

If there is going to be another house price crash it is likely to start with high-end properties, if so that would contrast with the 2008 subprime mortgage crisis with low-end properties.

The 2018 edition of the bank’s Real Estate Bubble Index, the Swiss investment bank compiled a list of the major cities around the world that are in or near bubble territory. Hong Kong was listed as the city most at risk of a real estate bubble.

Munich came second, then Toronto, Vancouver followed by Amsterdam, London, Stockholm, and Paris. New York came 16th on the list at risk of a real estate bubble.

See the full list of cities at risk of a real estate bubble. 

How can an investor construct an all-weather portfolio when diversifying in the everything bubble offers no solution?

Ray Dalio’s Holy Grail of investing is to diversify your investment portfolio with assets of uncorrelated return streams.

Dr. Dieter Rentsch, who runs Aquila Capital, Europe’s hedge fund of the year from 2010 to 2012 believes like Ray Dalio that real diversification can only be achieved with largely uncorrelated asset classes. 

But stocks and bonds are uncorrelated and many would argue are in a bubble.

Could the diversifying in the everything bubble in current times mean the diversification of haven assets using technical signals to determine entry-exit points? 

In other words, rotating from safe-haven fiat currencies, precious metals and sound sovereign bonds with positive yields. But the diversification of safe haven assets could also mean missing the upturn. So diversifying in the everything bubble is a real headache, particularly for pension fund managers.

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