First Quarter 2011 Newsletter

Quarterly Investment Commentary

Stocks continued their upward march in the first quarter, with large-caps gaining almost 6%, while mid- and small-cap stocks posted gains approaching 8%.  Overseas, returns were not as strong, though still good. Developed-market foreign stocks were up more than 3%, while emerging-market equities gained just under 2% for the quarter. Domestic high-quality intermediate-term bonds didn’t fare as well, barely gaining ground in the first quarter, while foreign bonds did a bit better, with developed-market government bonds gaining 0.7% and emerging-market bonds climbing by almost 3%.

We Are Not Bears, But We Are Cautious Now

For various stretches over the last 13 years we have been cautious towards the stock market based on our assessment of market valuations and expected returns. This has frustrated our clients at times, the late 1990s being the most notable example, as the S&P and NASDAQ rocketed higher during the late stages of the tech bubble. We wrote about our market concerns at that time, and our caution proved to be warranted. Despite another bear market in 2008, all of our portfolio models outperformed their benchmarks during this period, though there were a couple of performance slumps along the way—notably in 1998 and 2008.

As we reflect back and look forward, there are several points worth emphasizing.

  1. Our valuation-driven, scenario-based approach is designed to help us make good decisions over the long-term. We know we can’t predict short-term market movement.
  2. Even in the midst of long periods where returns are low there are still opportunities. In fact, these low-return periods are often characterized by higher volatility that can offer occasional fat pitches in “risky” asset classes like equities, REITs, and high-yield bonds. We have been able to take advantage of a number of fat pitches in each of the last two market cycles and they have contributed significantly to our return premium over the benchmark during this period.

Currently, we are positioned somewhat conservatively with our portfolio allocations, and there are a few important points to make in this regard.

We analyze return ranges for stocks by considering the possible economic scenarios we could see, and then considering how the “building blocks” of equity returns—dividends, earnings growth, and multiples— stack up under each. A challenge is that the range of possible outcomes is unusually wide, ranging from another recession to a return to the “old normal” patterns of borrowing and spending. We believe the odds skew towards the more negative outcomes, and this impacts how we want to allocate our portfolios.

Second, likely returns from bonds are even lower than stocks. With interest rates quite low, it is more likely that we will see rising rates (which push bond prices lower) than falling rates over our investment horizon. Without the tailwind of falling rates, and with yields on bonds starting at low levels, we expect only low single-digit returns from core high-quality bonds. Ordinarily, if we believe equity returns are likely to be higher than bonds, it would argue for being fully weighted to equities to capture that higher return.

That brings us to our third point, which is that with low expected returns for stocks and bonds, and with significant big-picture risks out there that could damage returns (especially in the shorter-term), we are underweighted to both stocks and core bonds in our portfolios in favor of investments that we think collectively offer better or at least competitive returns at less risk.

Examples of portfolio positions that we believe offer a better risk-reward tradeoff include:

  • Flexible, absolute-return-oriented bond funds that have a broad tool kit with respect to the types of bonds they can own and their ability to limit the risk of rising rates (PIMCO Unconstrained and Eaton Vance Global Marco); We have two other fixed-income investments that come with a notch-higher risk than the investments described above, but that similarly offer better bang for our risk buck. The multi-sector Loomis Sayles Bond invests in (among other things) carefully selected high-yield bonds and foreign bonds, mainly of commodity producing countries, which provides some hedge against a falling dollar. The other fund—PIMCO Emerging Local Bond—invests in the bonds of emerging-markets countries and is a more direct-dollar hedge. It offers an attractive 7% yield and the chance for greater currency appreciation if our longer-term assumptions that the dollar will decline prove correct.
  • Alternative Investments –The goal of these strategies is to hedge traditional financial market risk.   We do this with a number of strategies from traditional long-short to arbitrage to managed futures.   An example of what we have available to us today is AQR.    AQR is a traditional, blue-blooded hedge fund group out of Greenwich, Connecticut that until recently required a minimum investment of $1M.  Today, we are using two of their mutual funds (Diversified Arbitrage and Managed Futures), both of which we can access with a relatively small investment.

The final point we would make about our conservative positioning is that if we continue to see strong stock returns, it is likely our portfolios will lag their benchmarks. And while we did manage to outperform in 2010 despite a sharply rising stock market, we trailed in the first quarter of this year.  

So could the economy perform well enough to continue to drive the kinds of stock returns we’ve been seeing? Consumers could ramp up spending, and take on more debt, and the jobs and housing pictures could improve more quickly than we expect. But even if that happens to some degree, the deepest underlying problems aren’t going to go away as a result.

The deeper problem is that we have gone through a massive build-up of debt that occurred over many decades, and a lot of it still remains. Some of it has effectively been shifted to the government. With large deficits, a growing national debt, and entitlement spending on track to make these problems significantly worse over coming years and decades, it is inevitable that at some point as a nation we will have to take our medicine. When we do, it will mean we borrow less and spend less, which will reduce economic growth, and that will be a drag on corporate earnings and therefore stock returns.

It is in considering the headwinds the economy faces in the years ahead, and factoring in other big-picture risks such as Europe’s debt problems, unrest in the Middle East, Japan’s disaster, and other possible shocks we can’t foresee, that we conclude that the returns stocks are likely to earn aren’t sufficient to compensate us for taking on the risk. We’ve often said that we view investing as a marathon, not a sprint. We all are investors over a lifetime and any one year is a small slice of our investment timeline. Over our investing lives there will be periods when it pays to be conservative and others when it makes sense to be aggressive. Sometimes these periods will be short, others times they will last for years. Along the way there will be ups and downs within each of these periods. Our challenge is to ignore the ups and downs and focus on the potential returns we believe we can capture and weigh them against the risks.

Two final points about return expectations are that the equity managers we own can boost returns through outperformance, and many are indicating that at the stock-picking level they are finding good opportunities. Additionally, we are confident that inevitable periods of fear will drive certain asset classes lower and present us with opportunities to earn much more compelling returns in exchange for ratcheting our risk higher. This discipline and longer-term focus, along with careful underlying research, is the core of what we bring to the table as investment advisors.


Jon Houk, CFP®