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Saturday, 30 May 2009

Is Diversification A Strategy Of The Past?

Simon Maierhofer

In the early 80s, DOS was the most commonly used and recognized operating system (OS). In fact, DOS became the OS of choice and turned Microsoft into the leading software and computer technology provider. Newer Windows versions however, have proven more effective and reliable. At one point, MS DOS was the standard. Today, MS DOS is nearly obsolete.

Ever evolving products and standards are the result of a dynamic and efficient market place. The stock market dynamics of the last two years have certainly raised the bar and forced investors to rethink their strategies. Is diversification the financial equivalent of MS DOS?

For decades diversification has been the standard for many investors. The idea behind diversification is clear: exposure across multiple asset classes increases the odds of picking pockets of strength, just as placing multiple bets across the Roulette table gives you a higher chance of picking the winning number.

Pros and cons of diversification

A diversified portfolio for example, deflected the aftermath of the dot.com bust quite well. Even though the tech-laden Nasdaq (Nasdaq: QQQQ - News) and Technology Select Sector SPDRs (NYSEArca: XLK - News) lost some 40% in the year 2000, several industry sectors such as the Financial Select Sector SPDRs (NYSEArca: XLF) and Vanguard Consumer Staples ETF (NYSEArca: VDC - News) gained 20% and more.

On the flipside of the coin, regarding diversification and asset allocation, one could argue that placing bets on all sorts of asset classes doesn't make much sense. If you don't even fully understand the U.S. stock market, why would you want to commit money to international stock, bond, or commodity markets? If you can't even drive an automatic, why would you push your luck with a stick shift?

Investment strategies work... until they stop working. And more often than not, they become popular at the wrong time. Let's take a look at some numbers.

The year 2007 entered the history books as the last year of the boom and the beginning of the bust, at least for equities. The S&P 500 (NYSEArca: SPY - News) and Dow Jones (NYSEArca: DIA - News) were still able to eke out single digit gains, while commodities had started their final push to all-time highs.

International developed markets and emerging markets kept their winning streak alive for a little longer compared to U.S. equities, but were in a confirmed downtrend by early 2008. Global markets - previously considered 'decoupled' from the U.S. markets - became conjoined again.

Rising commodity prices in early 2008, neutralized losses in domestic and international equities. This continued until prices for wheat, corn, soybeans, oil, copper, nickel, and many other commodities plunged up to 70% within months of reaching all-time highs in Q1 08. ETFs affected include the PowerShares DB Agriculture ETF (NYSEArca: DBA - News), United States Oil Fund (NYSEArca: USO - News), and PowerShares DB Commodity Index ETF (NYSEArca: DBC - News).

With falling commodity prices, diversification had lost its touch. The onset of the financial meltdown was the beginning of the end' for diversified portfolios.

Even before the financial meltdown, the ETF Profit Strategy Newsletter considered financials a 'downward spiral with no stop-loss provision' and recommended to unload all asset classes in favor of short ETFs. Those short ETFs recorded double and triple digit gains in 2008 alone.

The end of diversification?

From the 2007 highs to the March 2009 lows, the S&P 500 lost 55.19%. How did a diversified portfolio fare over the same period of time? A portfolio with equal exposure to the Vanguard Total Stock Market ETF (NYSEArca: VTI - News), iShares Barclays Aggregate Bond ETF (NYSEArca: AGG - News), iShares Dow Jones US Real Estate ETF (NYSEArca: IYR - News), iShares MSCI EAFE (NYSEArca: EFA - News), iShares MSCI Emerging Markets ETF (NYSEArca: EEM - News), and iShares S&P GSCI Commodity ETF (NYSEArca: GSG - News) would have lost 48.12%.

Admittedly, 48.12% is better than 55.19% but either way investors lost about half of their money. That is simply not acceptable.

Did the 2008 meltdown usher in a new area that will render diversification obsolete just as windows did with DOS, or is the recent rally an indication that diversification bears timeless wisdom?

The ETF Profit Strategy Newsletter has become the default destination for profit minded investors. According to the newsletter, the bear market is not yet over. In fact, a deflationary environment will continue to put pressure on all asset classes.

Even the recent rally is no surprise to subscribers. The following was foretold in February: 'The best target for this low is 6,700 for the Dow and 700 for the S&P 500. Extreme pessimistic sentiment may drive the indexes even towards Dow 6,000 and S&P 600. A multi-month rally founded on this low should lift the markets by 30-40%.'

Despite the recent 30% bounce, the major indexes are still some 40% below their 2007 high watermark. At this point, it would still take an additional 75% rally and many years just to break even.

A pro-active, profit oriented approach on the other hand would put this mission on a fast track. By implication, a diversified approach always strings along weak sectors and asset classes that don't contribute to overall gains; in fact they often turn out as performance drag.

Rather than investing in a dozen asset classes (domestic and international small, mid, and large cap stocks, domestic and international bonds, commodities, real estate, etc.), many of which that are less than transparent, investors may want to consider investing in only one or two areas that offer the biggest and most likely profit potential.

While many lost 50% or more when the Dow Jones dropped from 14,000 to below 7,000, some actually used short and leveraged short ETFs to their advantage and recorded double and triple digit gains. Long-term indicators such as P/E ratios, dividend yields, the Dow measured in gold, and investor sentiment point towards new lows.

This will bring to an end (or at least put on hold) the era of diversification. Complacency will result in more losses. During the Great Depression, the Dow Jones lost more than 89% of its value. During those 34 months, there were five counter trend rallies with gains ranging from 25% to 50%. Only a pro-active, profit oriented approach protected investors from more losses.

The March and June issue of the ETF Profit Strategy Newsletter provided a detailed short, mid, and long-term outlook for the U.S. stock market, along with target levels for the ultimate market bottom. The Newsletters also included target levels for the end of this bear market rally, along with timely corresponding ETF profit strategies. Don't allow your portfolio to become extinct like MS DOS.

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