First Quarter 2005 Newsletter

Both stocks and bonds lost ground in the first quarter.

Despite volatility and uncertainty in the markets, we have not seen any asset class misvaluations reach our threshold for taking a tactical position. We remain confident that in the long run we will be rewarded for our discipline and selectivity.

We have defensive tactical allocations in our balanced portfolios to foreign bonds and commodity futures that we think amount to “free insurance.” In both cases, we believe we are able to protect our portfolios from specific (or general) risks without compromising return potential in most scenarios.

In our base-case scenario, we look for equity returns in the high single-digit range on average over the next five years (returns could vary widely in individual years). But there are a number of risks that could impact the fundamentals that underlie our assumptions, and we suspect that the market isn’t fully discounting the bigger risks. Therefore, we think it is prudent to manage our expectations a little lower than what the numbers are telling us.

Quarterly Investment Commentary

The first quarter saw mostly red ink in the financial markets. Somewhat unusual was that both stocks and bonds experienced losses. The S&P 500 was down 2.2% the first three months, while the Vanguard Total Bond Market Index Fund dropped 0.5%. Also unusual, mid-caps outperformed both larger- and smaller-cap stocks. Small-caps fared worst, with the Russell 2000 iShares dropping 5.4% for the year through March, while the Russell Midcap iShares were down only 0.2%. Among other asset classes, foreign bonds dropped about 2.6% in the first quarter, due to the dollar retracing some of its losses. Commodity futures, which we added to our balanced portfolios, had a good month in March and were the lone bright spot for the quarter.

Our portfolios were all down for the first quarter, ranging from a loss of a little over 1% for our Balanced portfolio to a little over 2% for our Equity portfolio. All slightly trail their benchmarks so far this year, but remain well ahead of their benchmarks over all longer time frames.

Volatility but No Fat Pitches

It has been more than a year since we unwound fat-pitch positions in High-Yield bonds. In the time since there has been no shortage of uncertainty. Concerns about sharply rising oil prices and overall inflation, rising interest rates, and risk to the dollar from our massive current-account deficit have all weighed on the markets.

While we don’t have any return-based fat pitches right now, it doesn’t mean we aren’t doing anything tactical. We own bonds on the short-end of the maturity scale in our balanced portfolios, because we expect interest rates to continue to drift higher. In the same models, we also own foreign bonds as a dollar hedge, and commodity futures for their return potential independent of equities. These aren’t “fat pitches” in the traditional sense, but rather something we refer to as “defensive fat pitches.” What does this mean? It means that they represent a way for us to directly hedge a specific risk (or reduce risk overall) without compromising the portfolios’ return potential in a base-case scenario. And we’d generally expect the defensive fat pitch to have at least a decent chance of even adding a little bit of extra return. Furthermore, in most cases we would expect the defensive fat pitch to benefit the portfolios even under other scenarios, some of which are negative. We consider them to be a “fat pitch” because of our conviction level in the payoffs: we believe that we’re getting what amounts to free insurance, or better yet, that we’re getting paid for that insurance. The depth of analysis and strength of conviction are the same as they would be for traditional return-based fat pitches, but the defensive fat pitches have differing criteria and play a different, but very important, role in our portfolio construction.

Asset-Class Update

Commodity Futures

Earlier this quarter, we added a position in commodity futures to balanced portfolios. Here are some of the key reasons behind our decision:

  • Commodities have done very well in recent years, and some of the arguments that fueled their rise were indeed compelling, but we suspected that much of the interest was driven by investors chasing recent returns rather than by fundamental analysis. We require a clear framework in which to evaluate the asset class and determine appropriate entry and exit points, and our research efforts focused on trying to get over this hump. We recently acquired new data and analysis on commodity futures that enabled us to evaluate this asset class with confidence.
  • Commodity futures generate return in several main ways. First, the futures contracts guarantee a set price at a future date, and commodity producers pay what can be thought of as an insurance premium for that certainty. Second, the collateral that backs futures contracts is invested and earns a return. Third, individual commodities are uncorrelated to one another, and as a commodity futures index is rebalanced a return is generated over time from reversion to the mean, as strong-performing, overweighted commodities are reduced and weak-performing, underweighted commodities are added. All of this is in addition to any returns that would come from price changes in commodities that are different than what the market was expecting—i.e., if actual commodity prices ended up being much higher than what investors were expecting, those future contracts would appreciate in price. That’s what makes commodity futures a good hedge against inflation.
  • Commodity futures have some very attractive diversification characteristics that we think are beneficial to the balanced portfolios: they often do well when stocks and bonds are doing poorly; many major macro-level crises are positive for prices of certain commodities, and their lack of correlation adds a nice level of risk control without having to sacrifice return potential.
  • On a long-term basis, we expect the returns from the commodity futures index to be somewhat similar to returns from a 65/35 mix of stocks and bonds. Our base-case returns, in fact, show commodity futures returning slightly less than equities on a pre-tax basis (and worse after taxes), which is why we haven’t added them to our equity portfolios, where we view our mandate as maximizing returns without as much focus on short- or intermediate-term risk management.

Commodity futures have been on a roll lately, raising the possibility of a near-term pullback.

Foreign bonds

Absolute yields on foreign bonds as a whole are now lower than in the U.S., which effectively raises the cost of our “insurance.” However, real yields are lower in the U.S. than overseas, which implies that their bonds might still be a better bargain on a valuation basis.

Given the huge decline in the dollar over the last few years one would normally expect our trade balance to improve. However, our current account deficit as a percentage of GDP has continued to worsen, recently reaching an all-time high. It is possible that the currency has declined enough that things will start to improve, but the extent of the current account deficit could demand further declines.

We don’t think a dollar crash is likely: the central banks of the world understand that a sudden, severe decline in the dollar would be terribly destabilizing to financial markets around the world, and so it is likely that they would present a unified defense of the currency in the event of a crisis. However, a dollar crash to us represents a scenario that would be sufficiently bad for our portfolios that we think it’s worth hedging, especially given that we think we can do so at little or no cost relative to domestic investment-grade bonds. And the continued ballooning of our current-account deficit suggests to us that further declines in the dollar are still likely, and therefore our foreign bond positions may continue to outperform domestic investment-grade bonds, while still providing insurance against a dollar crash.

Equities (U.S. and foreign)

In our base-case scenario, we expect both U.S and foreign equities to return high single digits on average over the next five years (returns could vary widely in individual years). On the positive side, though earnings are slowing, they are still likely to be in the mid single digits. And while interest rates are moving higher, it is quite possible that they will remain low enough to be fairly accommodative. Our valuation model assumes that rates are about 50 basis points higher than the current level and at that point the S&P 500 is still comfortably in a fair-value range. Other positives include relatively cash-rich corporate balance sheets and a pick up in capital spending.

But it is also important to recognize that the fundamentals that go into our valuation model can change, which would alter our return expectations. Some of the risks out there include higher oil prices, increased pricing pressure, rising health-care costs, etc., leading to lower-than-expected profit margins and earnings growth. Macro level risks—a dollar crash, a debt crisis, unexpected inflation, a large-scale terrorist attack, etc.—could result not only in big short-term moves in the equity markets, but could also materially impact the average return we see over a multi-year horizon.

We suspect the market isn’t fully discounting some of these bigger risks. At this point, we think the overall level of risk is probably a little bit higher than average, so we think it’s prudent to manage our expectations a little lower than what the numbers are telling us.

Investment-Grade Bonds

Inflation has been on the rise, and it isn’t just oil prices. Core inflation, which excludes the volatile food and energy sectors, has risen from a low of just over 1% in late

2003, to 2.4% as of February 28. This number is still reasonable by historical standards, but the rate of change has been more severe than what we’ve seen in many years. Our guess is that this number will continue to increase, and the Fed will continue raising interest rates, albeit at a measured rate. This backdrop is not terribly favorable for bonds, especially given the very low level of real yields. On the positive side, bond yields have indeed been climbing recently, and higher yields contribute to better nominal returns going forward.

We continue to see taxable investment-grade bonds as being overvalued and we have under-weighted this asset class in our portfolios. Municipal bonds are more attractive, and we are using them for all but very low-bracket investors. But given the risks out there that could lead to large or sudden drops in equity prices, we still think bonds have an important role to play in risk-control for balanced portfolios.

In Closing

Given the recent lack of compelling opportunities, we continue to look to our active managers as a source of added value. We can’t be certain this will be the case over shorter time periods, but our managers have added value over longer time periods and we are confident they will continue to do so. On the asset-allocation side, our current tactical allocations are geared toward containing risk in ways that don’t impact our return expectations. While there are no return-based fat-pitch opportunities, we continue to monitor asset classes closely, and stick to our discipline of waiting for only those opportunities that are highly compelling. By doing so, we believe that over the long term we increase the odds that the tactical moves we make will add value and help us continue to outperform our benchmarks.

As always, we thank you for your confidence.

Best Regards,

Jon Houk, CFP