Bull’s Eye Investing

John Mauldin reads a large volume of investment material each week. He carefully selects the best material and condenses it down to a few bite-sized chunks for readers of his email newsletter. He does the same kind of thing in Bull’s Eye Investing: Targeting Real Returns in a Smoke and Mirrors Market. He presents the views of others, adds his own remarks and presents a consistent theme. I found myself interpreting some of the details differently but agreeing with most of his conclusions.

Modern Portfolio Theory tells us to hold a diverse set of uncorrelated asset classes and to rebalance them on a routine basis. It tells us how to optimize our holdings.

John Mauldin identifies three problems with Modern Portfolio Theory right off the bat.

The first issue is that you must have 25-to-40 years as a minimum to be able to rely on the theory’s conclusions. Institutions have that much time. Individuals do not.

The second issue is that we don’t have the input data that we must have. The theory tells us how to adjust our allocations among a diverse set of asset classes to get the best combination of risk (as measured by the year-to-year volatility) and return. The trouble is that these allocations depend upon knowing the correlations among the asset classes, but they are constantly changing. Those who have tried to locate the best combination, the Efficient Frontier, have found that Mean-Variance Optimizers (MVO) fail. Sure, there is a best combination, at least in theory. But nobody can find it. The input data will not be available for several decades, if ever.

[The theory itself can allow for correlations to vary with time. But this causes a problem. It introduces a form of market timing.]

The third issue has to do with assumptions. The theory requires you to identify the means and variances of asset classes. What happens is that promoters use overly optimistic assumptions, especially regarding the intermediate-term. What is more, many asset classes are too new for us to have reliable information.

John Mauldin has looked at today’s market in every way imaginable. He sees a secular (i.e., long lasting) bear market in stocks. I agree. The evidence is overwhelming.

History and theory show us that market valuations return to trend (or, at least, back to the same neighborhood). History tells us that bubbles burst and valuations return to (more or less) reasonable levels. History and theory tell us that prices are linked to earnings, albeit loosely. History and theory tell us that dividends matter and that prices are linked to dividends. History and theory point to demographics. The disproportionate number of baby boomers entering retirement in comparison to the number of workers to produce the goods will push investment returns down. There are too many boomers paying for each dollar available from investments.

What are we to do? John Mauldin is a talent scout. He brings investors and hedge fund managers together. This is a task made difficult because it is against the law for hedge fund managers to advertise. There are a lot of people who would gladly accept your money. There are not nearly so many to whom you should give your money. In addition, hedge funds suffer an inverse form of survivorship bias. Successful managers are often forced to close their funds to new investors because of statutory restrictions. Many such success stories disappear from the view of the outside world.

John Mauldin tells us much about the world of hedge funds and hedge fund strategies. He does not tell us how to duplicate their results. In fact, he points to many niches in which it is impossible to duplicate their results without detailed, specialized knowledge. In essence, he tells us how to select some experts.

In a similar vein, he cautions against investing in gold and other commodities as an individual. Success requires extensive research and specialized knowledge.

He does leave some crumbs in the middle of the book for individual investors who manage their own money.

He points to the Gordon Model (or Dividend Discount Model). He presents it in its basic form. The total return equals the dividend yield plus the dividend growth rate plus or minus an adjustment for any change in the price to earnings P/E ratio. Next, he focuses on value and the implications of the equation.

John Mauldin points to the psychological factors that cause the value premium to persist. We cannot avoid them. We have to deal with them.

I still consider David Dreman’s 1998 book Contrarian Investment Strategies: The Next Generation to be the best in regard to value investing. But where David Dreman points out the psychological forces behind the value premium, John Mauldin spends time training us to see through the psychological distortions that we cannot avoid.

John Mauldin presents a set of rules related to stock selection that requires quite a bit of effort. He recommends forming investment clubs. He recommends diversifying extensively. He warns you that you must be extremely patient. He compares investing in higher dividend stocks and collecting dividends while waiting for prices to fall with staying on the sidelines and collecting none. He does not reach a conclusion. He mentions his personal preference. He prefers to wait in the hope that even better opportunities will surface.

He recommends against active trading. He believes that there really are traders with the necessary talent, a special feel. It involves digesting huge quantities of information and focusing on the right bits for the moment. There are not very many people with this talent.

As for bonds, John Mauldin recommends owning individual bonds and holding them to maturity. He recommends against owning bond funds. He recommends constructing bond ladders. He recommends against owning long-term bonds at today’s yields. He recommends owning high-quality international bonds to take advantage of a falling dollar over then next 5 to 7 years. He recommends against reaching for yield. Because of today’s low yields, he recommends being very careful about costs.

Have fun.

John Walter Russell
I wrote this on June 9, 2005.

[John Mauldin is the president of Millennium Wave Investments. To read his email newsletter, visit John Mauldin’s web site .]