Wall Street Journal: Right Forecast by Schiff, Wrong Plan?

Wading into the controversy surrounding Peter Schiff’s investment under-performance, the Wall Street Journal has released an article which calls into question the fundamental arguments for Schiff’s investment strategy.  Schiff, a fund manager often seen on television, has significantly underperformed the rest of the U.S. stock market, which itself saw a drop of nearly 40% last year.  The question is why.  Judging from the Journal piece, his approach was aggressive and ill-timed. To my mind, this calls into question whether these losses can ever be recouped down the line.  I have highlighted in bold the salient points of the article below.

Peter Schiff predicted a collapse of the U.S. financial system. The bust-up he didn’t foresee was the one that made mincemeat of investors who took his advice in 2008.

Mr. Schiff’s Darien, Conn., broker-dealer firm, Euro Pacific Capital Inc., advised its clients to bet that the dollar would weaken significantly and that foreign stocks would outpace their U.S. peers. Instead, the dollar advanced against most currencies, magnifying the losses from foreign stocks Mr. Schiff steered his investors into.

Investors open accounts at Euro Pacific to take advantage of Mr. Schiff’s investment advice, which generally involves shunning investments in dollars. Individual returns can vary. Some investors may like gold-mining stocks, while others prefer energy-focused stocks.

Most had one thing in common last year: heavy losses. A number of investors said their Euro Pacific portfolios lost 50% or more in 2008, worse than the 38% drop in the Standard & Poor’s 500-stock index last year. People familiar with the firm say that hardly any securities recommended by Euro Pacific brokers gained ground in 2008.

Such losses came as something of a surprise. Mr. Schiff’s prescient call for the collapse of the U.S. housing market and the weakening of the financial system helped him gain fame as an economic guru and savvy investor who promised shelter from the financial storm.

In his 2007 book, “Crash Proof: How to Profit from the Coming Economic Collapse,” he recommends that investors pile into gold, commodities and overseas stocks that spit out steady dividends.

My take here is this: Schiff made a macro call on the United States that was largely correct. However, he erred in investing based on that strategy in one specific way: he was aggressive during a period of extreme volatility, risking a substantial loss if he was wrong. The fact is we are witnessing an historic moment in the global economy. Prudence would suggest that a savvy investor, seeing increased volatility going forward, would position himself to limit his exposure to downside risk. This means reducing leveraged positions, reducing derivative exposure, and re-weighting out of risky assets and building up a reserve of cash. It does not appear Schiff has done so.

Nevertheless, in his defense, Schiff claims he is early, not wrong. But, is that really true?

Let me use a basic mathematical exercise to demonstrate my thinking here. Let’s say that you anticipate volatility in a market that had been rising 10% a year. This might mean losses or gains of 20% a year for two years. If you take $100 invested in these assets into a down market, you might lose 20%, taking you down to $80. In order to recoup your loss, you would need a gain of $20, which is a gain of 25%: greater in percentage terms than the previous loss. This mathematical relationship, which always holds true, is the primary reason it is wise to always protect against loss more than to seek gain.

Meanwhile, in order to return to the 10% annual gain level, you would need a gain of $30, which is a gain of 37.5% after the loss. These are large percentage gains that may never be achieved.

What this suggests is that risky bets during volatility can be fatal. Certainly, one sees the outsized potential for gain. But, it is outsized loss that kills long-term investment performance. This means one must always protect against loss. Schiff’s strategy was clearly designed to take advantage of the opportunities he saw. However his results suggest he did not have enough downside protection. In my view, this is a cardinal sin.

The Wall Street Journal article continues:

“It’s curious,” says one longtime client of Mr. Schiff’s who works in finance. “His thesis of how things are going to collapse and crumble and fall apart isn’t effectively executed in [my] account.” The account, which is largely invested in gold, mining and infrastructure stocks from Canada to Australia, was down roughly 35% last year, the client estimates. The Australian dollar weakened 19% against the U.S. dollar in 2008.

Mr. Schiff says one year’s poor performance doesn’t prove he was wrong. He has admitted in notes to clients that his investment thesis hasn’t performed as expected, particularly with respect to the U.S. dollar. But he holds fast to his convictions and has been telling investors to scoop up a number of depressed stocks.

I view this conclusion as at odds with the simple mathematical exercise I showed you above. This investor now has $65 for every $100 originally invested. If he expects 10% returns he would need to see $133.10 in two years (100 * 1.10 *1.10 *1.10). That means a doubling of his money over the next two years – 40% annual return if you will. I see this as unlikely. What about over 3 years? That would be $146.41 (100 *1.10 *1.10 *1.10 *1.10). From a base of $65, you are talking about a return of 125% over 3 years. Do you see that as likely?

My conclusion?  Simple math demonstrates the need for caution and reduced risk in volatile markets irrespective of how sure you are of your investment strategy. No portfolio can sustain losses of 35% without being set back many years from its eventual investment return goal. This is a truth Peter Schiff failed to heed in his investment strategy and his investors are suffering as a result.

Sources
Right Forecast by Schiff, Wrong Plan? – Wall Street Journal
So Why is the Journal (Sort of) Defending Peter Schiff’s Simply Wretched Investment Performance? – naked capitalism

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