Three Things I Think About – When Things Fall Apart

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Here are some things I think I think about:

1) Grantham calls for a stock market crash.

Here is a provocative article by Jeremy Grantham saying that we are in the 4th “superbubble” of the last century. I won’t spoil the uplifting read for you, but I’ll just say this – I don’t like making these kind of huge extremist calls because this kind of emotionally charged rhetoric tends to get people to make extreme portfolio.

If you think a crash is imminent, you switch to 100% cash. And now what? What is your plan to come back? You come back ? What if the market continues to rise? That’s the problem with these maximalist positions in things. You end up with hyper-emotional reactions to how the markets change over time.

What if Grantham was right? This is why we are diversifying. We diversify our savings precisely because we don’t know what’s going to happen in the short term and we want to insulate ourselves from behavioral biases.

So we accept the reality that one part of our portfolio is probably always going to perform poorly while other parts do better. You don’t have to worry so much about extremist predictions because a diversified portfolio makes you more behaviorally robust than the portfolio where you are exposed to asymmetric outcomes of outlier events.

2) Bonds no longer diversify?

There has been a lot of talk in recent weeks about how bonds no longer diversify a portfolio because bond prices have fallen along with stock prices. It’s hyper short-termism at work here. Let me explain with a simple example.

SHY is a constant maturity short-term bond ETF with an average maturity of 2 years. So the way to think about this portfolio is that its average holding has matured as long as you hold the fund for 2 years.

Below are the 2-year rolling returns for this fund. You will notice that there is no negative 2 year performance period because the average holding matures over two years.

In other words, if you treat a fixed-maturity bond fund as an individual bond, you must hold that fund for its average maturity to benefit from the actual underlying maturing periods that accumulate in the fund’s net asset value:

2-year average price (SHY, total return)

2-year average price (SHY, total return)

Looking at this more recently, SHY is down 1.1% since September, which gives the impression that it is not diversifying the portfolio. However, if the stock market drops 50% over the next two years from September 2021 levels, you can be pretty sure that SHY will be up slightly over the same period.

This will significantly dampen your portfolio no matter what happens in the short term, mainly because bonds, in terms of bear markets and volatility, are totally different beasts than stocks.

This is why I am a proponent of active-passive matching strategies. When you specifically compartmentalize your time horizons in your portfolio, you don’t fall into this trap of thinking very short-term, because you know that your SHY allocation shouldn’t be judged within a 2-month period when its underlying components are specifically designed to operate over 2 year periods.

3) The home bias is worse than we think?

Aswath Damodaran had a good Q1 data dump. Aswath does one of the most comprehensive looks at global business I have ever seen. And one of the most interesting things about his data is that he confirms something I’ve talked about in the past – the US market is much smaller than most people assume.

Many public ETFs like Vanguard Total World and MSCI All World show the US at 60% of total market capitalization because they use a free float methodology. If you use the full capitalization methodology like I do, you’re getting closer to 40% market capitalization in the United States. A full 20% difference.

Regional Breakdown by Market Cap

Regional Breakdown by Market Cap

Anyway, Aswath is awesome in case you don’t follow his work. Go dig into his data dump. lots of good stuff here.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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