First Quarter 2010 Newsletter

The first quarter of 2010 was a good one, with U.S. stocks enjoying healthy gains and bonds earning at least small positive returns. Our portfolios outperformed their benchmarks for the quarter and remain well ahead over the trailing 12 months.We have been expending a huge amount of research effort to thoroughly understand the overall environment and the various ways macro trends could play out. The main story is that the consumer needs to reduce spending now, in order to reduce the massive debt built up in previous years, suggests the strong possibility of a sluggish economy for many years to come.

We believe that risk assets like small company stocks are not priced attractively enough to fully compensate investors for the risks we see, However, periodic market declines in the years ahead could give us opportunities to improve returns by adding risk assets when we expect to be paid better for taking it on, and this will require patience.

Quarterly Investment Commentary

Following a strong March, all domestic equity asset classes are now well into positive territory year-to-date. The large-cap Vanguard 500 Index was up 5.4% for the quarter, while the iShares Russell Midcap benchmark gained 8.6% and the small-cap iShares Russell 2000 gained 8.8% for the first three months. Foreign stocks also posted strong gains in March and are now in the black for the year so far, with the Vanguard Total International Stock Index and the Vanguard Emerging Market Stock Index up 6.7% and 8.2% for the month, and 1.5% and 2.5% for the quarter, respectively.

Turning to fixed income, the domestic intermediate-term, investment-grade Vanguard Total Bond Market Index gave up a bit of ground (-0.1%) in March, though posted a positive 1.7% return year-to-date. Developed foreign bonds (as represented by the Citigroup World Government Bond Index) slid 1.7% in March and are down 1.3% for the year so far. Emerging-markets bonds gained an impressive 4% for the month (as measured by the JPMorgan GBI-EM Global Diversified Index), ending the quarter with a 5.4% return. High-yield bonds posted a 3.1% gain in the month, ending the quarter up 4.8%.

Our models all beat their benchmarks in the first quarter, and remain well ahead over the trailing 12 months. We talk more about our current views and future performance expectations in the commentary below.


Looking Down From 30,000 Feet, the Landscape is Dominated by Mountains of Debt

A year ago the stock market had just started its rebound from the depths of the worst bear market in over 70 years. The powerful rally in “risk” assets over the past year is certainly comforting. While we take some satisfaction in the returns we’ve achieved for our clients (and ourselves) since that time, we remain concerned, and our assessment of the key macro issues and risks that the global economy must deal with in coming months and years has not changed. Though the worst case of a great depression has been avoided, the global economy continues to struggle in the aftermath of massive wealth destruction and a hard stop to the decades-long trend of expanding indebtedness.

More so than in past periods, the investment climate in the years ahead will be highly influenced by how the key macro components of this environment unfold (i.e. Government Policy). We’ve seen massive growth in debt throughout society, reaching binge levels in the last decade. Think of all that debt as a form of borrowing against future consumption – now we must pay it back in the form of less spending. This suggests a sluggish economy, possibly for many years to come.

There is still a lot of government spending that will roll out this year, but unless there is a new round of stimulus, which is quite possible, it will dissipate in coming quarters / years.  Inventories will be a positive growth driver for a while as they are gradually rebuilt, but this too will pass as the year progresses.  Other sectors of the economy are strengthening – Manufacturing in particular has been impressive, but it is still far below its prior peak and overall the economy is on fragile footing.  What we don’t know yet is whether the economy will be on solid enough footing to stand on its own as government supports are withdrawn and inventories stabilize.

In normal cycles the consumer is the key to sustained growth.  The weakness in this critically important sector suggests to us that a sluggish recovery is the most likely outcome over the next couple of years and that there is still risk of a recession or inflation if government policies are not skillfully managed.  As most of you know, we don’t think government and skillful belong in the same sentence.

There are several important variables to a strong and sustainable economic rebound, but jobs are the most important. The big question is not whether the job picture will improve, but how much it will improve and how quickly. But while the labor market remains very weak, monthly job losses likely peaked some time ago, and we appear to be entering a period of net job creation.

A strong snapback in job creation at some point would not be shocking. With over eight million jobs lost, there was probably some overreaction on the part of businesses that will be reversed. However, we also believe that businesses are adjusting to a smaller workforce in the face of continued concern about economic growth in coming years. We don’t know how this will play out, but the weight of the evidence suggests to us that even with a strong temporary snapback, we shouldn’t be optimistic about a return to a strong labor market for several years.

There are some positives that could contribute to a better outcome, including continued strength from emerging economies.  Domestically, we could see stimulus spending, low rates, and inventory rebuilding create a virtuous circle in which businesses with strong balance sheets add jobs, and consumer and business confidence builds and feeds on itself. We certainly hope this is what happens, but we don’t think that it is the most likely outcome.


Global Stock Outlook

From where we are today (S&P 1200 and Dow 11,000) we think mid to high single digit returns are most likely for stocks over the next five years.  Our outlook for developed market foreign equities is similar and for emerging-markets equities is slightly higher across all scenarios.  We believe risks are relatively high, but we can’t predict timing.  We can easily imagine good returns in 2010 if the economy continues to grow, low rates encourage risk taking, and there is no catalyst to cause risk aversion.

 As we think about the equity markets, we also think about the potential for active managers to outperform, and we put some credence in the bottom-up views and analysis we hear from the stock pickers we respect. A number of relatively conservative value-driven stock pickers we talk to (e.g., the teams at Longleaf, Clipper, Osterweis, and Fairholme, to name a few) are quite bullish about the individual stock picking opportunities right now. Others, such as Crawford and the FPA team, are less so.  However, they are still able to find good investments; and, since they run relatively concentrated portfolios they don’t need to find a whole lot of them. There is some evidence that environments where overall stock returns are low but individual company returns vary widely are favorable for active managers; we believe we could see such an environment.

Emerging-Markets Local-Currency Bonds

Among other asset classes, emerging-markets local-currency bonds remain a compelling opportunity from a relative-return perspective versus the other major asset classes we track. We think it can generate mid- to high-single-digit returns in our most likely five-year scenarios—admittedly not spectacular returns, but better than most asset classes. The returns are driven by the underlying bond yields plus an expectation of at least mild currency appreciation we expect given the stronger fiscal conditions in much of the developing world.


High-Yield Bonds

We did very intensive work on high-yield bonds in late 2008. Back then we viewed high-yield bonds as an asset class that had better return potential than almost any other asset class and much less risk.  It worked out much more quickly than we expected and we captured a huge return in 2009.  High-yield has continued to do well in 2010, though the returns have been much more moderate.

As high-yield has rallied, we have reduced our exposure including a reduction earlier this year. High-yield could continue to generate decent returns in the short to intermediate term if the economy continues to gradually improve and interest rates remain low. But the huge increase in prices of high-yield bonds (now at or approaching par for most of the high-yield universe) means that our expectations for returns over our five-year investment horizon have fallen and we could be close to unwinding our remaining positions.


The Value of Our Research is in the Decisions We Make With It

Investment decisions involve determining if you are being adequately compensated for risk. We are concerned that risk assets like small company stocks are not priced attractively enough to fully compensate investors for the risks we see.  But periodic declines in the years ahead could give us opportunities to improve returns by adding risk when we expect to be paid better for taking it on—this requires patience.

The possibility that it may take years to complete the process of deleveraging is not uplifting. Skewing towards a positive view when the environment doesn’t support it may feel better, but is not a path to generating better returns, so we are committed to working hard to understand the reality we live in and make decisions accordingly. That said, we think a volatile, challenging environment plays to our strengths.  If we can do this successfully then our own outlook is decidedly better than the mediocre outlook suggested by the big picture and current valuations.




Jon Houk, CFP®