Portfolio Managers Face Their Kobayashi Maru
- Joshua M Brown
- June 23rd, 2013
Here’s Eric Peters from his Weekend Notes newsletter:
“There’s usually one time per year when everything goes wrong at once.” The S&P 500 topped at 1669 on May 21, and is now down 4.6%, while gold is -7.1% and 10yr yields are +57bps. “This is what happens after a Fed Chairman signals that you can buy any asset in the world without taking risk,” said the market’s biggest S&P trader, amused, buying back his last positions on the close. “Tell me, in a world without danger, how can there be safety?”
Josh here – The State of Asset Allocation, Summer 2013:
* Everybody is now low-cost, smart beta, dismissive of alpha – “just give me the sector exposure, hold the fees and friction”
* Nothing is safe, last week defensive sectors went down, growth names went down, dividend payers went down, small caps went down, large caps went down, international developed markets sold off, emerging markets sold off, junk bonds and treasurys dropped, mortgage bonds and REITs and investment-grade corporates dropped, precious metals dropped, industrial commodities and agricultural commodities dropped. If it had a ticker symbol, it traded lower.
* If there is volatility everywhere – even in normally non-volatile sectors, then traditional portfolio allocation and diversification stop working, at least temporarily. A no-win scenario in a game where there is almost always something winning.
We jump now to the opening scene of Star Trek II: The Wrath of Kahn – a young, drop-dead gorgeous Kirstie Alley, prosthetic Vulcan ears and all, sits in the captain’s chair on the bridge of a Star Fleet ship, calmly and cooly giving orders to her fellow officers as they attempt to rescue the mining vessel, the Kobayashi Maru. It’s become damaged and is sending out a distress signal, hull integrity and life support systems are failing, people are going to die. The trouble is, it’s stuck in a neutral zone and an incursion by Star Fleet – even for a rescue – swiftly prompts the attack by rival Klingon ships. The Captain – Vulcan Kirstie in this case – is faced with a no-win situation. If she honors the neutral zone’s border and abstains, the Kobayashi Maru is done for and everyone aboard is lost. If she directs her ship to begin a rescue attempt, the Klingon ships move in and destroy everyone.
In the film, the scenario is a simulation for training purposes. Star Fleet cadets are put through it in order to learn grace under pressure – it is a test not of intelligence or skill, but of character.
The way I see it, those managing multi-asset class portfolios have only a handful of options here to address this new no-win state of affairs across markets, should it continue:
1. Raise some cash – we did so early last week across several portfolio models but only in small increments. This may “feel better” temporarily it is not a great solution in that it presumes we can time the markets perfectly (we cannot) and it leaves us with a portion of our portfolios that has statistically zero chance of contributing any positive returns over time.
2. Add alternatives – are there “non-correlated” strategies that can be added now to address an atmosphere of highly-correlated asset class volatility? Sure. But you will find them extremely expensive and historically unreliable. No offense, this is my conclusion after researching scores and scores of arbitrage vehicles and volatility-hedgers and Black Swan funds and managed futures funds and long-short strategies and alpha-cloners and buy-write managers etc. If they don’t cost a fortune in management fees and internal expenses, then they’re too new or unproven to get comfortable with. And once again, you’re left with the conundrum of trusting a human market-timer to some extent – something you swore never to do again and all the data tells you is a mistake.
3. Clench your jaw, dollar-cost-average and ride it out – maybe this uptick in volatility continues all summer and maybe the S&P 500 correction stretches into something far larger than the 5% we’ve seen thus far. Adding to weakness based on either a systematic or a subjective rules-based framework is perhaps the hardest thing to do here but it’s the only true answer for a long-term portfolio. You will feel stupid and vulnerable doing it short-term, but gratified in the future. History virtually assures this.
The truth is, no matter which approach you take and what your time horizon is, a dropping market across all categories of bonds and stocks will make them all feel like no-win situations – at least in the short-term.
Back to the 23rd century – Kirstie Alley’s character, Saavik, chooses to rescue the Kobayashi Maru, all other options being equally unacceptable. Her attempt generates the expected response from the Klingons and everything is blown to smithereens. She loses just because she played. The concept of losing to develop character is perplexing to the young Vulcan so she pesters Admiral James T. Kirk, demanding to know how it is that he somehow “won” the scenario when he was a cadet.
Kirk is reticent to explain his old victory to Savvik throughout the film, until a crucial moment when it appears that all is lost. It is at this moment where he explains that the only way to win was not to play.
Saavik: Admiral, may I ask you a question?
Kirk: What’s on your mind, Lieutenant?
Saavik: The Kobayashi Maru, sir.
Kirk: Are you asking me if we’re playing out that scenario now?
Saavik: On the test, sir… will you tell me what you did? I would really like to know.
McCoy: Lieutenant, you are looking at the only Starfleet cadet who ever beat the no-win scenario.
Kirk: I reprogrammed the simulation so it was possible to rescue the ship.
David Marcus: He cheated.
Kirk: I changed the conditions of the test; got a commendation for original thinking. I don’t like to lose.
Saavik: Then you never faced that situation… faced death.
Kirk: I don’t believe in the no-win scenario.
I’m not playing by the market’s current rules. I’m not jumping just because the Vix tells me to. Nor am I allowing myself to be goaded into fancy, expensive, unproven alternatives just because they purport to have the answers. I’m not buying into the premise that all asset classes continue to drop in unison, I’m not getting sucked into the parameters of that particular simulation where nothing can work. Something eventually will work because everyone needs a return on their money at the end of the day. If 2.5% yields on the 10-year aren’t juicy enough, perhaps 3% yields will be. If a 13X forward earnings ratio on the Dow Jones Industrial Average combined with a 2.47% yield isn’t tantalizing enough, maybe a 12X and 3% dividend yield will do the trick.
Something’s got to break the right way.
Because, like James Kirk, I don’t believe in the no-win scenario either.
Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see my Terms & Conditions page for a full disclaimer.blog comments powered by Disqus
The Reformed Broker is a blog about financial markets and the economy. Joshua Brown is a New York City-based investment advisor for high net worth individuals, charitable foundations, retirement plans and corporations... More.