TMFDeej (99.47)

It is important to be comfortable with uncertainty

May 07, 2009 – Comments (3)

I have mentioned several times that I was somewhat surprised by the current rally in the market.  Despite being caught off guard by it, my personal and CAPS portfolios were positioned fairly well to tolerate extreme moves in either direction, up or down.

I redeployed a huge chunk of my retirement and non-retirement accounts in the bond market at the end of 2008 when credit spreads were about as wide as I have ever seen them.  I was able to put myself at the top of the capital ladder (though one has to question if that is worth as much as many originally believed it was when looking at what the current administration is trying to pull with Chrysler and GM) and collect yields that are on average around 10% while trying to figure out if the economy will eventually recover or we are going to drift off into a nightmare.

The bulk of the rest of my investment funds are deployed in dividend paying common and preferred stock, with a tilt towards value.  I went with preferred stock for the riskiest companies that I believe will continue to survive despite their serious problems, like Chesapeake Energy, Wells Fargo, Goldman Sachs, and Bank of America.

I went with plain old common stock for companies where preferred stock was not available but I liked the story, like General Mills, Unilever, Johnson and Johnson, and a number of pipeline operators.

I wanted to retain some exposure to oil, despite the fact that inventory levels are at a record level, demand is very low, and the U.S. dollar is strong.  The picture for oil sure looks bearish to me, but it keeps on rallying and I (along with everyone else) don't really know what is going to happen in the near future.  I chose to make my stand in the oil sector with the company that I know best, a Canadian Royalty Trust aka CANROY names Penn West Energy (PWE).  Management there has made some moves that are annoying lately, like slashing the dividend only a month or two after assuring investors that it was safe, but for the most part I like what they have been doing operationally.

Anyhow, the point of this post is that no one knows for certain what the markets are going to do in the near future.  Anyone who claims to is only making an educated guess, some of which are much less educated than others.  I'm still fairly bearish on the economy and I have positioned my portfolios conservatively.  The high yields, high positions in the capital structure, and tilt towards value of most of my positions will protect me inn the event that things get a lot worse, but by being long without any short positions I am benefiting from the current rally.

A quote from the great author F. Scott Fitzgerald sums up my philosophy on the current market excellently:

The test of a first rate intelligence is the ability to hold two opposed ideas in the mind at the same time and still retain the ability to function.

Here's what John P. Hussman has to say about uncertainty in his excellent weekly newsletter:

Buddhist teacher Pema Chodron calls it “being comfortable with uncertainty” – being willing to take every aspect of reality as the starting point, without wasting energy wishing things were different, without denying reality as it is (even if your next step is to work toward changing things), and without needing to know what will happen in the future. “The truth you believe and cling to makes you unavailable to hear anything new. The best thing we can do for ourselves is to be open to an unknown future.” Burton offers the same advice. Tolerating the unpleasantness of uncertainty, he writes, “is the only practical alternative to cognitive dissonance, where one set of values overrides otherwise convincing contrary evidence. Each position has its own risks and rewards; both need to be considered and balanced within the overarching mandate: Above all, do no harm. Science has given us the language and tools of probabilities. We have methods for analyzing and ranking opinion according to their likelihood of correctness. That is enough. We do not need and cannot afford the catastrophes born out of a belief in certainty.” Our objective is always the same – to outperform the S&P 500 over the complete market cycle, with smaller periodic losses than a passive investment strategy. To that end, we spend much more effort identifying market conditions and their associated return/risk profiles than we spend on predicting them. The difficulty in the bull/bear distinction is that bull and bear markets don't actually exist in observable reality, only in hindsight, and it is futile to base an investment position on things that can't be observed.

Well said.

Deej