Second Quarter 2005 Newsletter

Returns varied in the second quarter but most asset classes were in the black.Interest rates are an important variable in setting return expectations and developing portfolio strategy.

Whether rates rise or stay low has little impact on bond returns over the next five or so years. For equities, plugging low rates into a valuation portfolio generates unrealistically high return expectations, especially given that it would likely be a weak environment.

There are structural risks that we are seeking to hedge that aren’t impacted by whether rates stay low for a few more years or not.

Regardless of the French and Dutch votes on a European constitution (which led recently to weakness in the euro), the reasons we own foreign bonds are unchanged. To us, the risk of further declines in the dollar remains, particularly against non-euro currencies.

Quarterly Investment Commentary

The second quarter saw a variety of returns among the major asset classes. The S&P 500 gained a modest 1.4%, while the smaller-cap Russell 2000 chalked up a solid 4.3% gain. Bonds rallied, with the Lehman Aggregate index moving up 3%. The equity managers in our portfolios—as a group—held their own during the second quarter, but the shorter duration of our fixed-income allocations, along with our foreign bond and commodity positions (both of which experienced losses), caused those portfolios to underperform their benchmarks. Going forward, our base-case expectation is that equity returns will average in the high single-digits to low double-digits, whereas bond returns—due in large part to their extremely low absolute yields—are going to have a hard time gaining beyond the low single digits, although they still provide important diversification in the event of a large equity market decline. (Of course, there is a range of possible outcomes, and our base-case is simply the mid-point of the outcome we think is most likely.) Among the equity asset classes, we view small-caps as being slightly pricey relative to large caps, we are neutral between value and growth (although we have seen some evidence suggesting that growth stocks are becoming more attractive on a valuation basis); and view foreign stocks as having slightly higher return potential as compared to domestic equities.

Bond Return Assumptions

It might surprise some that the difference between a 6% 10-year Treasury and a 4% Treasury over a five-year time frame isn’t huge from the standpoint of expected returns for our bond positions. In a 6% 10-year Treasury world, the returns for the Lehman Aggregate (our benchmark for our core bond positions) would be around 3.2% annualized over five years, vs. 3.9% in the 4% Treasury scenario. The timing of the rate changes would impact the actual returns but the differences still aren’t huge. As a comparison, cash yields almost 3% right now. So realistically we’re talking about very small variations in return from one scenario to another.

Equity Return Assumptions

From an equities standpoint, the issue is murkier. Plugging a 4% 10-year Treasury and a historically modest average of 3.5% nominal growth in earnings into a conventional discount-cash-flow valuation portfolio generates significant (mid-teens) returns for stocks. Intuitively, that high a return in that kind of environment just doesn’t make sense. A 4% Treasury world would likely be accompanied by very low global aggregate demand and significantly lower corporate profits, and investors wouldn’t be likely to “pay up” for stocks in the midst of weak growth just because rates are low. The reason the return expectations come out higher than what we think common sense dictates is because most valuation portfolios (including ours) are based on “discounted cash flow,” where the present value of future earnings is based on an interest-rate assumption. When rates are very low, the present value of future earnings is very high. (This is precisely the reason why the poor-performing Japanese market has perpetually looked “cheap” based on interest-rate derived valuation portfolios.)

Incidentally, even if our portfolio assumes very slow earnings growth—which we are by no means discounting—the impact of low interest rates still results in a forecast of mid-teens equity returns. So it makes sense to be conservative in our analysis and we accomplish this by setting a floor for our discount rate of 5%, which in essence means that we assume a higher risk premium in very low-growth, low-rate environments. In these environments not only is inflation low but also investors are probably worried about deflation, which is why the risk premium would be higher.

The French and Dutch “No” Votes on the European Constitution

The realm of politics is something to which investors tend to assign more weight than is deserved (except perhaps when it comes to a coup in an emerging market). Sure, the European Union could come unglued, though we think it’s unlikely. And regardless of the French and Dutch votes on a European constitution, the reasons we own foreign bonds are unchanged. To us, the risk of further declines in the dollar remains, particularly against non-euro currencies. We have yet to see a good answer to the question of how big a current account deficit is actually sustainable, but at an all-time high of 6.4% of GDP, we find it hard to imagine that we’ll be able to avoid additional meaningful declines in the dollar at some point. And furthermore, we see the risk as being somewhat asymmetrical: the risk of a strong, persistent dollar appreciation seems much less likely than strong dollar depreciation over the next 3-5 years. If the euro vanished, there would probably be a short-term rally in the dollar as a “safe haven” currency amid the turmoil, but our structural imbalances would remain, and longer-term dollar depreciation would still need to take place. Of course, there could be real economic fallout from European disunity: confidence in their capital markets could deteriorate, falling currencies and weak growth could lead to stagflation, and so on. But historically it has been difficult to say with much confidence how currency movements play out in the real economy.

The dollar has dropped a lot in real terms versus major currencies (euro, yen, Canadian dollar, U.K. pound, etc.) but much less so versus other important trading partners (including China, Asia ex-Japan, Mexico and several Central American countries, Saudi Arabia, and others). So while the declines we’ve already seen might in theory eventually improve our current account deficit, in functional terms the declines have not yet taken place in many of the areas where they are most needed. One of the ways we may be able to address this issue is by researching a new fund option that might more specifically target the regions against which the dollar is most likely to experience the biggest declines in the event of a dollar crash. Switching funds could have tax implications (though at this point they look immaterial), and this is something that could be worth considering if we identify a fund that provides us with a more efficient “defensive fat pitch.” In particular, we have begun work on PIMCO’s new Developing Local Markets fund. We will let you know if and when we make any changes.

As always, we thank you for your confidence.

Best Regards,

Jon Houk, CFP®