First Quarter 2004 Newsletter

In the first quarter we decided to reduce our tactical allocations to high-yield bonds, bringing our equity exposure back to neutral.

Equity valuations are in a fair-value range and it’s unlikely that these asset classes will return much more than their dividend yield plus earnings growth. If true, intermediate returns will likely be in the 6-9% range.

While stocks are not overpriced, we are not motivated to take above-average risks in light of the nominal returns that we expect. Furthermore, there are a number of structural risks, as well as geopolitical risks, that make us somewhat cautious. But we are not at the point where we believe it makes sense to get defensive.

Looking forward, our long-term return expectations are not high for the underlying markets, and our ability to add value at present is somewhat limited by the lack of compelling asset-class opportunities. The coming months may require some patience. Inevitably, the market will again present us with compelling tactical-allocation opportunities. Until then, we remain confident that our managers will continue to add value.

Quarterly Investment Commentary

The powerful stock market rebound that started just over a year ago continued in the first quarter, though most of the gains occurred during the first few weeks of the year. Small-caps and foreign stocks were especially strong, and both outperformed the S&P 500. High-yield bonds managed to deliver good returns on the quarter, while investment-grade bonds did quite well as interest rates declined in January, February, and March. Foreign bonds also delivered positive returns in the first quarter, though they were generally lower than U.S. bond returns.

Our investment approach is patient and long-term-oriented, and as a result portfolio turnover is normally infrequent. However, this quarter was an exception, as we made significant changes to our portfolios, including unwinding our fat-pitch exposure, fine-tuning our allocations to better account for cash and style exposure at the fund level, and adding FPA New Income to the Fixed Income portion of our portfolios to gain greater diversification in our bond holdings. We discuss the basis for adding FPA New Income and for eliminating our tactical positions in more detail below.

New FPA Income is an eclectic investment-grade bond fund run by Bob Rodriguez and Thomas Atteberry. Currently the fund is positioned very conservatively, with an average duration of only 1.1 years and a meaningful allocation to cash, as the team expects interest rates to increase significantly over the next 12-18 months; this is why we partially funded the purchase of this fund from the cash positions in portfolios. The appeal of this fund is partially due to our long-term expectation that interest rates are likely to rise. Equally important, we have a high degree of confidence in this fund’s management team and like their highly flexible approach to seeking value over a market cycle.

The elimination of our return-based fat-pitch exposure reflects that the investment landscape today is very different than it has been during much of the past five years. During that period, we experienced an unusual abundance of fat-pitch opportunities, as the tech bubble left large swaths of the financial asset market ignored and undervalued. At various points over this period of time, we established tactical over-weightings to value stocks, small-cap stocks, foreign stocks and high-yield bonds. Each of these asset classes provided incremental outperformance during the full period that we held them and this contributed to the performance of our portfolios. The ability to put in place multiple “fat-pitch” plays also allowed us to diversify them so that very high exposure to any one asset class was unnecessary. But all good things come to an end. We have eliminated more then half of our high-yield bond holdings this quarter, and will most likely eliminate the remainder in the next few months.

Why We Reduced Our High-Yield Bond Position

Yields offered by high-yield bonds have been steadily declining for well over a year now and are near all-time lows. Spreads (the difference between yields on high-yield bonds and Treasury notes) have narrowed tremendously in the last couple of years, and we believe are now so sufficiently low that they are failing to price in some of the structural risks that we have discussed over the last year. Though fundamentals have improved with a sharp drop in default rates, this improvement is already reflected in bond prices. Another way of assessing the appeal of this asset class is through expected returns, which are no longer competitive with equities. (Junk bond yields relative to stock earnings yields are near their lowest level in two decades—essentially the entire history of high-yield bond asset class). Even compared to a blend of equities and investment-grade bonds, high-yield bonds cannot compete on an after-tax basis.

The Investment Climate: Should We Be Cautiously Optimistic or Just Cautious?

For some time now, our forward-looking view of the investment climate has been driven by several factors:

Valuations for equity-type asset classes are in a fair-value range. This means that over an extended time period it is unlikely (though not impossible) that these asset classes will return much more than their dividend yields plus their earnings growth. If true, this puts intermediate expected returns in a 6-9% range. Also important is the level of interest rates because this can have an impact on stock prices. As we all know, interest rates are exceptionally low. Using the 10-year Treasury as a reference point, if rates rise much above 5%, stock prices could be adversely affected, resulting in lower returns. The 5% level may seem like a long way away from today’s 4.0% yield but from a historical frame of reference, 5% is still a very low rate, and rates have the potential to spike up to that level in a matter of months. (In 2003, rates were as low as 3.1% in June and as high as 4.6% less than three months later.)

Structural risks continue to be an intermediate-to-long-term risk factor. These risks include:

  • The current account deficit, which is mostly driven by the trade deficit. We import about 50% more than we export and as a result, we need to “import” foreign capital to help us pay for it.
  • Public and private debt levels. The question is whether the collective “we” that make up the net worth of the United States hold too much debt. Absolute debt levels are very high historically but low interest rates make the servicing of this manageable. A concern is what will happen when rates rise? Will it slow borrowing and spending growth? This would dampen economic growth.

Inflation/deflation is another risk down the road. The substantial monetary stimulus provided by the Fed for some time now raises the risk of inflation. And China’s booming economy is another factor that adds to that risk. However, outside of commodity price inflation (which over the years has become a relatively small component of overall inflation), inflation remains muted at present. But, if the economy continues to improve it’s possible that inflation could move significantly higher (though we don’t expect 1970’s style out-of-control inflation) in coming years. How can we be concerned about both deflation and inflation? Deflation could occur if, as discussed above, borrowing is reduced, leading to a reduction in consumption (demand). This could happen on its own or it could happen after an initial increase in inflation and interest rates that could then serve as a catalyst to reduce borrowing (because of higher interest rates). We don’t think this scenario is too likely but it is possible, and if it did happen it could be economically dangerous. For this reason we are not willing to ignore it out of hand. Though both these concerns are not imminent in our view—getting the timing right is difficult.

Geopolitical risks have not gone away. Terrorism risk impacts costs for governments and some companies, and terrorism-related economic shocks remain very much a wildcard.

The economic cycle is relatively early, which suggests that economic growth is likely to continue for several years before another recession. Though the early-cycle gains for stocks have already been strong, normally at this stage of the cycle equity-type investments would still have several more years of outperformance compared to defensive investments (on average—not necessarily every quarter or year). Stimulus remains strong, supporting this expectation.

The message we take away from our analysis is that, though stocks are not overpriced, there is not much margin of safety and the nominal returns we expect don’t motivate us to take above-average risk. The environment we describe is the same one we described three months ago. This potentially low-return period we’ve forecasted for some months now has led us to research many different asset-class options and funds as we’ve sought ways to add incremental value. In recent months we’ve looked at short-term bond funds, commodities, and various alternative investment funds. Outside of the FPA New Income Fund, none of these areas has yielded results, though we continue to work on at least one alternative investment option. But, late in 2003 we completed research on foreign bonds and added exposure to our balanced portfolios as a way to provide insurance against a falling-dollar scenario with an asset that we think is likely to deliver higher returns over the next few years compared to our investment-grade bond alternatives.

Though there are no guarantees, we expect the equity funds we own to do better than the market averages over the long run (though over shorter periods of time, such as one year, we are less confident in their outperformance). However, looking forward from here our intermediate return expectations are not high for the underlying markets, and our ability to add value at present is somewhat limited by the lack of any hugely compelling asset class opportunities. So it is also very possible that the coming months will require patience as we wait for more exciting investment opportunities. Investing isn’t easy and the need for patience is one reason why. We do know that sooner or later, there will be a catalyst that will cause investors to overreact and push one or more asset classes into bargain territory—to our potential advantage.

Best Regards,

Jon Houk, CFP®