The broad economic environment remains highly stressed, and there is a great deal of uncertainty as to what the impact of the recently enacted government policies and programs will be.

Broadly speaking, the near-term imperative is to prevent a debt-deflation spiral from taking hold and that is the basis for policy actions. But longer-term these actions are likely to come at the cost of lower growth, higher inflation, and dollar weakness.

We consider four broad economic scenarios that we believe are reasonably possible in assessing valuations and potential returns for equities and other asset classes.

Short-term risk remains, and investors should consider now how they would react to another significant decline in the stock market.

Quarterly Investment Commentary

Stocks saw their best one-month gain in March in more than six years, but while it was a welcome respite from the battering in January and February, the first quarter still ended with a double-digit loss for equities. The large-cap S&P 500 (based on Vanguard 500 Index Fund) surged by almost 9% in March, yet finished the first quarter with an 11% loss. REITs after a very strong move up the last six weeks of 2008 were beaten sharply lower as investors reacted negatively to deteriorating fundamentals and fears about debt rollovers, and after a weak rebound in March finished the quarter down 32.1%. High-yield bonds, on the other hand, had the best showing of any of the broad asset classes we track, with a gain of 5.3% for the opening quarter. Abroad, the results for developed-market equities were similar to what we saw at home. Vanguard Total International Stock Index Fund gained over 9% in March, but their 13% loss for the quarter was a bit worse than that of domestic equities. In contrast, emerging-market equities had a great March and finished the first quarter slightly in the black, based on Vanguard Emerging Markets Stock Index Fund. Turning to bonds, Vanguard Total Bond Market Index Fund was up 1.5% for the month, bringing their year-to-date results slightly into the black.

Although we are obviously not happy to see another down quarter for our portfolios, we are encouraged that relative performance has been strong versus our benchmarks so far in 2009 (as well as in the final month of 2008). This reflects value added in aggregate from our tactical asset allocation positions as well as improvement in the performance of our active managers. While this is admittedly a very short time period, it is a welcome change from 2008 when our active managers significantly detracted from our performance.

As we do in each quarterly commentary, we will update you on our current thinking about the investment landscape. We will also spend some time going into thorough detail on our analysis and outlook for equities in particular as well as other asset classes. In all, this commentary is unusually long.


Recap of the Current Economic Situation

The list of issues affecting today’s investment landscape is dizzying; at the top is the dismal state of the global economy. The fundamental problem is that over the past several economic cycles U.S. households and financial services businesses took on increasing amounts of debt in order to fund consumption and investments. This trend was self-reinforcing as purchases with borrowed money drove up asset prices (such as homes and financial stocks) and profits, which supported even more borrowing. Ultimately this upward spiral was unsustainable, and its unwinding has created an adverse feedback loop of falling asset prices and lower spending and profits. As the economy deteriorates, contributing factors (such as rising unemployment, mortgage defaults, loan write-offs, reduced lending, and overall fear) all fuel one another.

In such a situation, most experts agree that the government needs to step in as a consumer and lender of last resort to try to stop or mitigate the effects of this adverse feedback loop. In effect, the public sector (the government) must take on more leverage and spend more in order to try to plug the gap created by the deleveraging in the private sector. The $800 billion fiscal stimulus package and the monetary and credit policy actions undertaken by the Federal Reserve and the Treasury to support the financial and credit markets are the result so far.

We agree that stopping a debt-deflation spiral from taking hold is very important, but there remains a lot of uncertainty as to how the government’s efforts will play out. Generally speaking, we think that the policies and programs recently announced are likely to help move the economy towards recovery, but they may not alone solve the serious problems we are facing and we expect more government action in the months ahead. In our opinion, no matter what policies are introduced, the impact of consumer and financial system deleveraging will almost certainly be a significant drag on economic growth over the next several quarter and maybe even the next several years, as saving and paying down debt replaces borrowing and spending. We also believe that there will likely be a price to pay down the road for the current policy actions in the form of a weaker U.S. dollar, higher inflation, higher interest rates and tax rates and, consequently, subpar economic growth and corporate profits, with lower-than-normal stock market valuations (P/E multiples).


Our Outlook for Equities

The analytic framework for our equity return ranges—and the resulting asset allocation decisions—starts with four broad economic scenarios that we think have a reasonable likelihood of playing out over the next five years. We derive assumptions regarding earnings growth and valuations (P/E multiples) for the S&P 500 that we believe are consistent with each economic scenario. Our earnings and valuation assumptions are based on our analysis of stock market and economic history going back to the 1920s as well as a qualitative, forward-looking assessment that accounts for differences between this cycle and prior economic and market cycles.

Each earnings growth path and P/E multiple implies an ending value for the S&P 500 five years hence. We can then calculate the approximate rate of return from capital appreciation and dividend yield for each of our scenarios. We can also test the sensitivity of the results to different growth and valuation assumptions. These scenarios and return expectations are not predictions. Rather, having calculated a range of potential five-year returns for equities (and other key asset classes as well), we use the results as key inputs in determining our tactical portfolio weightings.

Our four broad economic scenarios are as follows:

Scenario 1: “Muddle Through” – Economic recovery in late 2009/early 2010 but sub-par recovery for several years. Inflation gradually rises at the end of the five year period.

Scenario 2: “Stagflation” – Economic recovery in late 2009/early 2010 but sub-par recovery. Strong inflation (mid single digits) near the end of the five-year period.

Scenario 3: “Severe Recession/Deflation” – Extended/deep recession and potential deflation through 2010 due to severe deleveraging and negative wealth effects. Recession does end but recovery is anemic.

Scenario 4: “Goldilocks” (i.e. not too hot, not too cold) – Government policies are effective and economy starts growing in the latter half of 2009. An average recovery with moderate inflation.

Over the past several months we have spent a great deal of research time analyzing historical earnings and stock market cycles going back to the turn of the century and thinking about how the current cycle might play out over the next several years. We have focused a lot of attention on our worst-case severe recession (Scenario 3). In the past, we have been comfortable assuming the economy will go through normal cyclical downturns (recessions) and recoveries. But starting with the events last September, we no longer think that is the most likely outcome given the deleveraging/negative spiral process we appear to be facing. (Although we don’t think a normal recovery is the most likely outcome, we do not rule it out — see Scenario 4). This has led us to study the U.S. experience in the 1930s — the last time our country went through a massive deleveraging process — as well as more recent financial/banking crises in other countries.

We believe the growth path for corporate earnings over the next five years will likely fall somewhere between the worst post-recession recovery since World War II and the Great Depression (which saw the biggest drop in earnings in U.S. history). In our worst-case scenario we lean towards the latter. Note that we are not expecting the overall economy (GDP) or the unemployment rate to be anywhere near as bad as during the Depression. But we think the impact on corporate profits could be comparable. This is based on our judgment taking into account the extent of leverage in the system that must be unwound, balanced against the unprecedented fiscal and monetary actions the government is taking to prevent a repeat of the Great Depression.

We think that scenario 1 and 2 are the mostly likely to play out, but given that there has been a lot of press and especially a negative view (i.e. Great Depression 2) I though I would walk thru what this could look like….once again it is not what we expect.

Our Worst-Case Scenario

In our worst-case scenario (Scenario 3), we assume a peak to trough decline in nominal S&P earnings of about 65%. This compares to a 75% decline during the Great Depression and is worse than any other earnings decline since then. We think the trough earnings will likely occur around the middle of this year. From the trough, we assume earnings rebound at the median rate of post-World War II earnings recoveries for the first two years and then assume they revert to the long-term trend rate of roughly 6% growth. We think these are conservative assumptions because we are not assuming the sharp recovery in earnings that typically happens after sharp earnings declines. Again, this reflects our concern about the high amount of leverage in the system and the potentially long-lasting effects of its unwinding. As we come out of the current contraction, consumers may be reluctant to take on debt, and bank lending (which will also likely be more-heavily regulated) could be cautious, contributing to a subdued earnings recovery.

The above assumptions give us an estimate of S&P 500 earnings of about $51 five years out. To this earnings number we apply two valuation multiples. In one case we assume a P/E multiple of 16x. This is roughly the multiple we observed in the period after the earnings trough during the Great Depression. In the other case, we assume a lower multiple of 13x to account for the possibility that market psychology may be depressed if our worst-case economic scenario plays out. There are other macro risks as well, such as dollar depreciation and higher-than-expected inflation—both of which might compress valuation multiples. The market has experienced P/E multiples lower than 13x, but that has typically been during periods of high inflation (the 1970s), world war, or when earnings are growing very rapidly (e.g., after World War II) – none of which we expect five years from now in this scenario. So we feel that 13x is sufficiently pessimistic as an end-point multiple. But this does not mean the multiple couldn’t drop below 13x at some point during the next five years.

Multiplying the P/E multiple and our earnings number gives us an estimated S&P price level five years from now. We then calculate the annualized price return and add the estimated dividend yield to derive our return expectation. From the quarter-end S&P level of around 800, five-year estimated returns in this scenario are not attractive (roughly -1% to +3%) though not a disaster and would probable be a comparable return to US Treasury Bills. While we don’t believe our most negative scenario is the most likely outcome, we want to show that from this point (S &P 800) there is not much risk of loss.

Our Optimistic Scenario

In our most optimistic Goldilocks scenario (Scenario 4), we assume that S&P earnings revert to their long-term earnings trend line five years from now. Prior to the events of last summer when the financial crisis began to intensify this was our baseline scenario. That is, we assumed the most likely outcome was that we would experience a normal recession/expansion cycle and so our best guess was that in five years time earnings would be at or in the neighborhood of their very long-term earnings trend line (which reflects a 6% long-term average annual growth rate going back to the 1920s). However, given the deleveraging process as well as the potentially challenging longer-term consequences resulting from the current government intervention, we now view this scenario as less likely than our more negative scenarios, but still one that is reasonably possible and that therefore deserves to factor into our decision making.

This scenario generates an earnings number of around $86 five years out. We apply an 18x P/E multiple, which is consistent with long-term historical average P/Es during periods of moderate inflation and normal economic growth. From the S&P around 800, this scenario suggests a stock market return of around 17% per year over the next five years. Such a return would be very attractive in both absolute terms and relative to the other asset classes we follow.

Our Other Scenarios

Our other two scenarios generate potential returns that fall between Scenarios 3 and 4. We won’t go into the details here, but qualitatively, both scenarios assume earnings growth better than in our worst-case scenario although still not as strong as in a normal cycle. Once again we believe that scenario 1 and 2 are the most likely outcomes. If 1 or 2 does play out as we have indicated, then our asset allocation will look much different in five years then it does today.

Active Equity Managers May Add Significant Value in this Environment

We continue to hear from the majority of our equity managers that they are finding tremendous, once-in-a-generation opportunities right now. In our conference calls with them we’ve discussed numerous stocks they own where they see 2x, 3x, or even bigger upside from current prices. While they don’t claim to know exactly when the market will reflect what they believe is the true underlying business value for these companies, they are highly confident that it will happen over the next several (typically, three to five) years and their shareholders will be well rewarded. They also argue, and we agree, that the price moves may be quick and sharp, as is typical coming out of a bear market, so one needs to be invested now and remain patient in the mean time.

Our portfolio allocation decisions are based not only on our return expectations for equities, but those of other asset classes as well. Our views on other major asset classes follow.


We continue to hold a tactical allocation to high-yield (junk) bonds in our balanced portfolios. We don’t own high-yield bonds because we are optimistic about a quick or strong economic recovery. To the contrary, we expect this severe recession will lead to historically high default rates for junk bonds, quite possibly exceeding levels seen in the 1930s Depression. We also believe recovery rates from defaulted bonds will reach historically low levels. (Recovery refers to the value ultimately recovered by bondholders after a company defaults and restructures or its assets are sold. For example, a 20% recovery rate means the bondholder receives 20% of the face or par value of the bond.) Despite these pessimistic assumptions, our analysis suggests that the high-yield market is priced to compensate us for these risks over our five-year horizon. That is, we think the market has overshot on the downside and that the longer-term fundamentals support higher prices.

In implementing our exposure to high-yield, we continue to own a combination of active managers, all of which are currently more conservatively positioned than the benchmark. These funds have minimal exposure to the default-prone CCC-rated part of the market, and are concentrated in higher-quality bonds (e.g., BB-rated). The funds also have selective exposure to investment-grade credits, as well as bank loans, which are higher up in a company’s capital structure and theoretically less risky. Because of the funds’ more-conservative postures, the yields on these funds are lower than the index. Though the yields are lower, our expectation is that they will have lower defaults and higher recoveries than the index, and therefore their total returns should be in line with the index.

Since we established it late last year, our high-yield position has generated a positive return. As always, there is the risk of short-term volatility: just because we believe an asset class is fundamentally cheap doesn’t mean it can’t get cheaper. Another short-term risk is that if there was a sharp upward move in the high-yield market the funds we own would probably underperform the high-yield index due to their more conservative positioning. However, our active managers, to varying degrees, have said they will be willing to take on more risk (i.e., lower credit quality and higher yield) if and when they believe the fundamentals and expected returns justify such a move. All in all, we remain very confident in our high-yield tactical position.


The reason we made a small tactical allocation REITs back in November was we believed that they had upside similar to equities, but limited downside because of a high dividend. There have now been some developments that put the high dividends at risk. Though we had already factored in large dividend cuts and huge property price declines into our analysis we have made further reductions to our forecasts in most of our scenarios. Our opinion has also been influenced by the IRS Revenue Procedure that was issued late last year, after our REIT purchase. The procedure allows REITs to pay up to 90% of their dividend in stock rather than cash during 2009, and now looks like it may be extended into 2010. Though we had believed our REIT assumptions were adequately pessimistic several months ago (more conservative than others we were aware of) the impact to dividends from the IRS change coupled with the liquidity squeeze and deterioration in fundamentals has led us to consider even more conservative assumptions in our REIT valuation model.

At current levels, we believe REITs are priced to generate returns similar to U.S. equities over the next five years in the scenarios we think are most likely to play out, but without the high dividends, we are not as confident that they have any less risk than equities. Because our views have changed and REIT returns now don’t appear to us to have more upside than equities, we are considering whether this holding is still justified. For now we remain comfortable holding our 3% to 5% REIT position in lieu of equities. However, REITs continue to be incredibly volatile in the current environment, and we could move to quickly sell them if they have a sharp run-up relative to equities. As always, our return expectations for other asset classes relative to REITs will also impact our sell decision.

Emerging Markets Equities

Based on the valuation measures we look at, emerging markets do not yet look convincingly cheap relative to U.S. equities. They look slightly attractive on a trailing price-to-earnings (P/E) basis, but not on a price-to-book-value (P/B) or cash-flow yield basis. Emerging markets trade at a trailing P/E of about 8x, well below their historical average of 16x. They now trade at an 18% discount to developed markets on a trailing P/E basis. Historically, they have traded at a median discount of over 23% and an average discount of 21%. We believe the historical average does not fully reflect the improvements in emerging markets fundamentals, i.e., we think the P/E discount should narrow over the next five years. So, based on P/E, emerging markets look attractive relative to both their own history and developed markets. However, looking at trailing P/B, which has been a more stable valuation measure than trailing P/E, emerging markets trade at a slight premium to the developed world. While some investors argue that emerging markets’ relatively high growth prospects warrant a valuation premium, they have generally traded at a discount to the developed world in the past because of their political uncertainty (which can lead to changes in macro policies that are not conducive for growth), susceptibility to macro shocks (this risk has diminished as macro fundamentals of emerging markets have improved), and relatively less-liquid markets. Finally, emerging markets do not look cheap when we compare their cash-flow yield relative to that of developed markets over time.

Our valuation analysis is also heavily influenced by our earnings scenario work. But unlike U.S. equities, where we have many decades of earnings data, we have just over one decade of reliable earnings data for emerging-market equities. So, we have to rely heavily on judgment.

Developed International Equities

For developed international, we focus on analyzing fundamentals of Europe and Japan since they make up the majority weighting in a developed international index. Economic conditions in Europe look at least as bad as they do in the United States, if not worse. Like other regional equity markets, Europe looks cheap relative to its own history. However, the question that we spend most of our time on is how it stacks up versus U.S. equities. Europe looks fairly valued relative to U.S. equities on cash earnings, i.e., when depreciation and amortization charges are added back to earnings. In addition to valuations, we assess the risk of foreign currency depreciation versus the U.S. dollar, since it eats into a dollar-based investor’s returns. Currency appreciation was the primary reason why European equities outperformed U.S. equities for several years prior to the current financial crisis. The euro appreciated significantly and got to the point that it looked overvalued versus the dollar on a fundamental (purchasing power parity) basis going into 2008. Our belief was that as the euro got more in line with long-term fundamentals, this would pose a headwind to a dollar-based investor investing in Europe. Since the onset of the financial crisis, the dollar has appreciated versus the euro and the euro now looks fairly valued versus the dollar. Our view on Japan is mixed. The country depends heavily on exports for its growth and the recent contraction in global growth has hurt its economy such that it appears to be on the brink of deflation again. Equity valuations have started to look interesting though. In addition to looking very cheap relative to their own history, Japanese equities offer higher earnings and cash-flow yields than U.S. equities. However, the question we are assessing is whether or not this is fair compensation for what we believe is a relatively poor long-term earnings growth profile for Japan.

Bringing our views on Europe and Japan together, we think developed international equities will likely provide similar returns as U.S. equities over the next three to five years.

Investment-Grade Bonds

We continue to view the investment-grade bond universe, outside of U.S. Treasuries, as offering attractive investment opportunities resulting from the severe dislocations in the credit markets. Corporate, mortgage-backed, and municipal bonds all appear to offer good value. In our tax-exempt accounts, our investment-grade bond exposure comes from holdings in Loomis Sayles Bond, Yield Quest Total Return Bond, and PIMCO Unconstrained Bond funds, which in aggregate provide highly diversified exposure to a variety of bond market sectors.

The team at Loomis Sayles views the BAA-rated investment-grade corporate bond sector as most attractive right now and has almost 40% of their portfolio there. They also hold roughly 20% of the fund in high-yield bonds, as well as roughly 25% in non-dollar bonds. The fund’s yield to maturity is 11%, reflecting its attractive longer-term total return potential.

PIMCO Unconstrained are more conservatively positioned than Loomis Sayles, with significant allocations to high-quality agency mortgage-backed securities in addition to a large weighting in corporate bonds. They also have smaller exposures to munis, TIPS, and non-U.S. securities.

Intermediate-term municipal bonds, which we own in most taxable accounts, have had a modest rally this year and are outperforming the taxable bond index by roughly three percentage points. This reverses the trend from the last half of 2008 when munis sold off sharply due to a variety of technical and fundamental factors. However, munis remain relatively attractive.

A Brief Word on Inflation and the U.S. Dollar

In previous commentaries we have discussed the potential consequences for inflation and the dollar of the current government efforts to reflate the economy. The most recent policy announcements from the Federal Reserve only serve to make us more cautious about a weakening dollar and increased inflation pressures at some point down the road (e.g., in the later years of our five-year horizon). As such, we continue to think about hedges against dollar depreciation and inflation. Although we still believe deflation is the primary concern for the time being, we are assessing the attractiveness of Treasury Inflation Protected Securities (TIPS), particularly in our most conservative portfolios that have a very heavy allocation to fixed income. TIPS appear to offer relatively cheap insurance against inflation right now. We also continue to follow commodities as an asset class and are also studying gold. While we would expect commodities to perform well in an inflationary environment, they can also be quite volatile and would probably perform poorly if the global economy continues to deteriorate. (This was one factor contributing to our sale of our commodity futures position in March 2008.) The same is probably true of emerging-market currencies, which we also previously owned as a dollar hedge. Thus, we are being cautious about reintroducing them into our portfolios right now despite our longer-term worries about inflation and the dollar. There will come a time to protect our portfolios from raising inflation and the depreciating dollar…it just is not now.

Shorter-Term Risk Remains

We continue to stress that there remains significant short-term downside risk in the stock market. Though as we write this the market is in the midst of a 20%+ rally from its March 9 low of 676 on the S&P, we know that rallies of 20% or more within longer-term bear markets are the historical norm, not the exception. Prudent investors should be prepared for the possibility that the S&P 500 index could decline back to those March 9th levels and even below. To be clear: we are not predicting the market will drop and we don’t believe a decline back to March 9th would be a permanent loss of capital.

Shorter-Term Uncertainty Creates Longer-Term Opportunity

Investor psychology is a powerful force that can overwhelm rationality. We’ve seen this throughout history on both the upside and downside. Markets can and do overshoot what a rational analysis would suggest is fair value. While this can cause discomfort in the short term, it can also create terrific investment opportunities for those able to identify and willing to take advantage of such mispricings. We are working hard in applying our analytical and research capabilities towards identifying such opportunities, and we will act with discipline and conviction when we view the risk/reward as compelling. We have been successful doing so in the more than a decade we have been managing assets, and we are confident the market will continue to provide us with compelling opportunities to add value in the months and years ahead.

But taking advantage of those opportunities also requires patience, since we know that unless we are very lucky we won’t get the timing of our tactical moves exactly right. We will probably be early since markets tend to overshoot fundamentals, and our decisions are based on fundamentals. So the market will probably go against us for some period of time after we make a move, and that could be a trying experience since it will feel scary to own an asset class that has been performing terribly.


We Are Taking Nothing for Granted

We have talked a lot about the risks and uncertainty in the economy and the financial markets. At the same time, we want to emphasize that we are resolutely focused on meeting these challenges with process and discipline. In addition to analytical expertise, conviction, and patience, we think our ability to navigate this environment and make effective long-term decisions requires that we think creatively, expand our knowledge base, continually challenge our analysis and assumptions, seek new data, and discuss our views with other experts in the field, in particular those whose analysis or opinion may differ from ours. We want to think carefully about how we could be wrong, particularly in terms of assessing the downside risk. We also need to have the intellectual honesty and humility to change our view or admit a mistake if we find that the original reasons for our investment thesis no longer hold true as a result of new developments. (The evolution of our analysis of REITs is an example of this.) These are all core elements of our research process. They have been critical to our past success and, we believe, bode well for our ability to continue to add value for our clients in the future.

Although we think a tough road is likely in the months ahead, both for the real economy and for the financial markets, ultimately we are confident that the economy will emerge from this deep and painful period, albeit on a more subdued growth path than in past recoveries. We hope we are positively surprised and that a sustainable recovery takes hold more quickly than we expect and that our optimistic scenario plays out. But we are not managing our portfolios based on that hope. Instead, as always, we strive to analyze the situation rationally and in depth, weighing the potential risks, rewards, and outcomes in order to make the best investment decisions we can on our clients’ behalf. No matter whether investor psychology has created a market bubble or a bust or something in between, sticking to those principles gives us a sound decision framework that is grounded in rational analysis and not emotion.

We remain strongly committed to focusing everything we do on rewarding you for your confidence.


Jon Houk, CFP®