|We are making several portfolio changes, including eliminating our commodity futures position and eliminating TCW Select Equities.
The credit crunch problems facing the financial sector and potentially the overall economy are more complex and more severe than anything we’ve seen in recent times.
There are some positives, including strong exports among domestic companies, and the Fed’s commitment to formulating a strong policy response that addresses the underlying issues plaguing the financial system.
Stocks are reasonably priced given a shallow recession, stocks aren’t pricing in a severe recession, but further declines could lead to attractive valuation levels.
Quarterly Investment Commentary
Stocks were down sharply in the first quarter. A few strong days at the end of March were not enough to offset the pain of the roughest quarter we’ve seen in five years. Large-cap stocks were off by almost 10% for the first three months of the year, with Growth modestly underperforming Value. Mid and small caps were down by roughly equivalent levels of around 10%, and growth’s underperformance of Value was more significant as market-cap dropped. International stocks also had a rough quarter down over 10% for the first three months. In the equity markets there was no place to hide, which is very typical of bear markets. Commodity futures and emerging-markets local-currency bonds both did very well, gaining 9.6% and 4.7%, respectively, based on their indexes. REITs managed a decent quarter, with a 2.2% gain, while high-yield bonds were off by 3% as bond investors shunned risk.
Model Portfolio Changes
We are making several changes to our portfolios this month. We are eliminating our positions in commodity futures and putting the proceeds in PIMCO Developing Local Markets and Investment Grade bonds. The short explanation is that we think the increasing economic weakness combined with the strong run up in commodity prices in recent months outweighs the longer term diversification benefits of owning commodity futures at this time. We are also eliminating our positions in TCW Select Equities, which had a manager departure, in favor of Touchstone Sands Capital Institutional Growth (in some portfolios). We are also making minor adjustments to the weightings of several other equity managers, to improve our overall level of manager diversification.
Our Investment Views
In the 2001 Berkshire Hathaway Annual Shareholder Report, Warren Buffet wrote, “You only find out who is swimming naked when the tide goes out.” Well the tide has gone out and it’s not a pretty sight. Though we wore our swimsuits, it is still ugly. Unfortunately, some of our managers did not fully appreciate the economic risks regarding financial stocks that have now become apparent. There were a handful of observers who saw this coming and here we must credit Bob Rodriguez of FPA Capital who not only foresaw much of what has happened, but even wrote and spoke publicly about it months before the credit markets became dysfunctional.
We have often said that accurate economic forecasting is difficult and therefore we rely on valuation work and scenario analysis as the basis for investment decisions. That approach has been helpful to us in this environment but it’s likely that we are not yet out of the woods. Conventional wisdom would say that we created a bottom in the markets when Bear Stearns got bailed out on Monday, March 17th, but considering the market didn’t decline by at least 20% from its highs, we think that more downside risk is very possible. Otherwise, we believe it is likely that we are now closer to the end than the beginning of the bear market.
Through this very tough environment the US equity portion of our portfolios has slightly trailed their benchmarks. The pattern of the past couple of years has continued with our asset-class moves, in aggregate, adding value that has been slightly more than offset by the underperformance of several of our equity fund managers.
This quarter we’ve chosen to communicate with you in a Q&A format because we believe it is the most reader friendly and efficient way to explain our thinking on a range of sometimes complex topics, not all of which will be of interest to all readers:
What is your view of the U.S. economy?
Though the label is unimportant, it’s probable that we are near a recession or on the verge of entering one, we will not know until the end of July. It’s clear that the severely troubled housing and credit markets are beginning to have an impact on the health of the overall economy. The worst phase of the credit market problems could last for several more months, and the housing problems could continue into 2009. High energy costs don’t help but are not the primary concern. The problems facing the economy are clear:
- Housing: With a massive backlog of unsold homes and waves of foreclosed properties continuing to hit the market, it could take a year or longer to get inventory levels back to normal. The weakness in the housing market reduces wealth and spending, increases unemployment, and continues to contribute to dysfunctional credit markets. As you can see from the graph, housing prices have increased faster than income the past 10-12 years and long-term; we know this is not sustainable.
- Dysfunctional Credit Markets: The bottom line is that credit markets are not functioning properly at present. There is an adverse feedback loop in play with losses from leveraged entities forcing them to sell assets (deleverage), which triggers more losses, and so on. The ability to borrow money at a reasonable cost to support consumer spending and conduct business is essential for a healthy economy. Perhaps even more important to a stable economy is the ability to refinance maturing debt. The longer the problem lasts, the more damage there will be to the economy.
- Labor Market and Consumer Spending: We are now beginning to see a clear weakening in employment. A weak labor market could feed back to trigger more defaults as people have a harder time servicing their debts. This could delay recovery in the housing and credit markets and become a self-reinforcing cycle. Meanwhile, declining consumer spending has and will impact corporate profits.
It is also worth noting that while most of the rest of the world is doing better than the U.S., Japan’s economy is also struggling and Europe’s is slowing. It seems likely that most of the developed world will continue to weaken. The emerging markets are in better shape, however, we don’t expect them to be fully immune from economic weakness in the developed world.
What are the positives?
The biggest positive for the economy in the near term is the aggressive, and in some respects, unprecedented action of the Federal Reserve. Though the Fed’s moves have not been as effective as they would like, they have made it clear that they will do what it takes to stop a major downturn and they still have weapons in their arsenal, such as directly buying mortgage securities in the public market.
The dollar’s weakness has also significantly improved the competitiveness of U.S. businesses versus foreign competitors. Export strength is already happening with exports contributing a significant one percentage point to economic growth over the last six quarters (annual rate). This almost offsets the economic impact thus far of the housing downturn. This benefit could diminish if the global economy weakens significantly, however.
Finally, outside of the financial sector, companies are generally flush with cash, especially relative to debt-service needs. Balance-sheet strength is surprisingly healthy for this late in an economic cycle—the result of strong profit growth and below-average capital investment in recent years.
Do today’s economic stresses have any longer-term economic ramifications?
There are two potential long-term ramifications. First, as the Fed and policy makers attempt to break the adverse feedback loop, the amount of stimulus that is being required increases the potential for higher inflation down the road—not 1970s style inflation, but more than we’ve been accustomed to. Inflation is unlikely to be a near-term problem because a deleveraging (debt reduction) and recessionary environment is deflationary not inflationary. But longer-term, the increased supply of dollars has to go somewhere and that raises the risk of inflation. It also undermines the dollar’s value relative to other currencies. That’s also inflationary as imported goods cost more. The second ramification is the likelihood of continued deleveraging on the part of households for several years, resulting in slower credit growth (less borrowing) in the next recovery. If consumers borrow less and spend less, economic growth and corporate earnings growth will be slower than they would otherwise be. All this raises the risk of some stagflation in the next economic cycle.
How would you summarize JPH Advisory Group’s current investment posture?
While we think stocks are fairly priced, there are few compelling asset class level opportunities; however we do have two noteworthy tactical moves in play.
- U.S. equity exposure is overweighted to larger companies and underweighted to smaller companies based on relative valuations and economic-cycle factors.
- We continue to hold a portion of our fixed-income exposure in emerging-markets local-currency bonds.
What investment moves is JPH Advisory Group considering?
We our often asked if stocks or when stocks will be at a point to increase our equity position. This is not something we take lightly, because it goes with the core of risk management. In the event that stocks continue declining another 10% or so we would consider making additional tactical purchases of equities. This is an important part of our discipline that helps to ensure that we will not hesitate when presented with good long-term opportunities in the face of what would be a very negative immediate stock market environment. It is also possible that we will have tactical opportunities in areas such as REITs, high-yield bonds, and International equities. If this happens, we expect to adjust our strategy to allow for exposure to multiple opportunities.
As we write this, market volatility continues—however, we suspect this will continue to be one of the most challenging investment environments we’ve faced, at least for a while. But stocks are reasonably valued now, and if they fall much further, it will represent an attractive buying opportunity for long-term investors. And while we believe it is important for us to discuss the more negative possibilities, we reiterate that it is possible that we are close to a bottom, or that we have already reached a bottom. We can’t know what the near-term is going to bring, but at times like this when economic uncertainty is high, our discipline and research process keep us grounded and give us confidence in our ability to make sound long-term decisions.
We appreciate your confidence and trust.
Jon Houk, CFP®