Additional Thoughts on the ?New Normal?

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The following is in response to a letter to the Editor from Larry Katz which appeared last week. That letter was in response to Geoff Considine’s article, What the New Normal Means for Asset Allocation, which appeared two weeks ago.

I received a number of positive responses to my article, The New Normal and Asset Allocation. A less-than-enthusiastic comment (see here) was sent in by Larry Katz, the Director of Research at Merriman, Inc. Mr. Katz took the time to draft his critique because I used one of Merriman’s published model portfolios as an example of the current standards in strategic asset allocation.

Mr. Katz’s responses are representative of the views of the ‘old normal’ in portfolio construction, and its tenets still form the bedrock of the investing world view of many advisors and investors. In the interest of maintaining a productive dialog, I have addressed Mr. Katz’s responses in the comments below.

Mr. Katz’s concerns with my proposed ‘New Normal’ world view are many, but the main issues can be summarized below:

  1. Mr. Katz believes that adjusting a portfolio to reflect the ‘New Normal’ themes described by PIMCO amounts to a ‘forecast’ – and that forecasts of future economic conditions are very uncertain.
  2. The inclusion of individual stocks is too risky and that the potential default risk of holding individual stocks is too high. It is far better to own some of everything in the market via market-cap weighted indexes
  3. Mr. Katz believes strongly that a portfolio tilt towards value and small cap stocks is a key source of value—and my portfolio is tilted towards large-cap stocks.
  4. Mr. Katz believes that I made a mistake by having a lower overall exposure to developed international equity indexes, as a whole, if the dollar does become weaker.
  5. Mr. Katz apparently does not believe that statistical measures of risk (such as portfolio Beta, volatility, and R-squared) are meaningful and prefers to rely on more qualitative risk measures such as the percentage of the portfolio in bonds and the total number of stocks in the portfolio.

There are other minor issues, but these are the big ones.

The idea that using a ‘forecast’ is too risky is easily cleared up. If you don’t believe that PIMCO’s New Normal is a compelling world view, don’t adjust your portfolio to reflect it. Mr. Katz finds fault with the heavy tilt of the New Normal portfolio towards the emerging markets vs. the developed markets, but this is one of the key tenets of the New Normal forecast.

My article was not a justification of the New Normal, but rather a discussion of how one might adjust a portfolio if they believed in the New Normal. There is, however, a further wrinkle. Any portfolio allocation reflects a ‘forecast.’ In Merriman’s case, the forecast is that the historical value added by a small-cap and value tilt to a portfolio will persist. There is nothing wrong with this world view - but it is a forecast. PIMCO’s New Normal is based on the idea that the financial world is changing in some fundamental ways.