MPT's Revenge

You're hot then you're cold
You're yes then you're no
You're in then you're out
You're up then you're down

- Katy Perry

This pop star's comments may well describe many investors' activities over the last several months - to their own detriment. Most agree a long-term approach is correct, but what is long-term, anyway?

Modern Portfolio Theory (MPT) is effectively the basis for every finance graduate program in the country and has been since its formulation in the 1970s. An accumulation of fancy Greek symbols and seemingly rational concepts, MPT is a tool used to create an optimal portfolio given a market's and investor's constraints.

Because investments tend to have correlations less than 1.0, we can theoretically build an optimal portfolio that, through diversification, will return a maximum amount over time for a given level of risk tolerance. Even tools such as leverage can be included in these formulations.

An underlying theme is that investors should look to the long term for returns, focusing little on the market's wiggles and waggles. Unfortunately, what constitutes a wiggle or waggle is left for the market to determine. Is a three-year downturn a wiggle or is it a substantive event demanding a change in formula inputs? How about a 10-year downturn as the stock market recently reflected?

Also, note the assumption that correlations are less than 1.0. After last September's events (and even during times leading up to them), many correlations moved very close to 1.0. This created a perfect storm of falling investment prices, which in turn led to further investment losses as investors panicked and sold, moving to "cash" or money market mutual funds.

For years leading up to this crisis, total investments in money market funds hovered around $2 trillion. Today, we are around $3.5 trillion. As these extra funds work their way back into the system, investment prices must necessarily rise. This is what we are seeing today.

The S&P 500 is up 55 percent since its March 9 trough with other risk markets following along. Even commodities continue their rally with gold reaching a new recent high of over $1000 per ounce last Friday.

Record new issuance of Treasury securities at rock-bottom rates continues to attract solid demand as investors shift from "cash" to "anything with yield." Are investors really buying 30-year Treasuries at 4.18 percent for value? Will they hold them for 30 years?

According to the Investment Company Institute (ICI), over $56 billion has flowed into stock mutual funds since April. On a comparative basis, this is about a 0.5 percent increase in total funds invested in the stock market. As a trend, pure buying power could easily continue to outweigh historical valuation techniques, fueling a stock market rally (bubble?) even as the economy continues to languish. The same is possible in all other risk or even Treasury markets.

Some have argued MPT is dead, but perhaps we just have to redefine our wiggles and waggles.

At the end of the day, fish have to swim and investors have to invest. The sidelines are no place for professionals.

Key Developments

Consumer credit outstanding declined by a record -$21.6 billion in July after falling $15.5 billion in June. The current six-month decline is the longest losing streak since the credit crunch in 1991. It is clear consumers will have to fund activity going forward in a more rational and less levered manner than in the past.

Consumer sentiment measured by the University of Michigan's index increased to 70.2 in September from 65.7 in August. Though off the lows of the mid-50s, consumer sentiment has a long way to go to get back to the 90 area experienced a little over two years ago. Given consumption drives the American economy, it is safe to say activity in this post-recessionary period will be tepid at best.