|2004 was a good year for the markets and our portfolios. Our portfolios beat their benchmarks for the year, and are well ahead of their benchmarks over all longer time periods. Our bond holdings out-performed by a wide margin, while our US and international holdings outperformed, but by a smaller margin.
It is worth remembering that less than two years ago sentiment was dismal, but the market had more than discounted the risks; therefore, returns since that time have been very good. Today people are thinking less about risks, but there is also less of a valuation cushion and some of the same big-picture risks remain.
Structural imbalances in the U.S. economy are still risks that impact our investment decision-making. We continue to own foreign bonds to protect against a dollar collapse. We think this is unlikely, but it could be very damaging and we think we can gain protection with no cost to our upside.
We think most asset classes are either close to or above fair value, making our managers especially important in adding value to our portfolios.
Quarterly Investment Commentary
Stocks finished the year with a strong fourth quarter, bringing the full-year gain to a healthy 10.8% for the S&P 500. Small-caps did even better, gaining slightly more than 18% this year. Comparing value and growth, value held a big edge, with the Russell 3000 Value index gaining almost 17%, while the Russell 3000 Growth index was up just 7%. Foreign stocks, measured in dollar terms, also had a great year, increasing by roughly 21%.
Investment-grade bonds, despite starting the year somewhat overvalued, managed a decent year, with the Lehman Aggregate Bond Index up about 4.3%. High-yield bonds did quite well, with the Merrill Lynch High Yield Master benchmark gaining almost 11%. Given junk bonds’ low spreads over investment-grade bonds, we did not view the asset class as compelling from a valuation standpoint and so we sold our positions early in the year. Foreign bonds, thanks to sharp declines in the dollar during the final months of the year, had a good year overall, with the Solomon World Government Bond Index gaining 10.4%.
Things Felt Different Two Years Ago
In looking back on a good year, it is worth remembering back to early 2003 when even a decent year for the markets seemed to be wishful thinking. At that time, we were coming off of the most dismal year of the three-year bear market, and sentiment was extremely poor. Stocks continued to decline ahead of the Iraq invasion, the economic recovery had yet to gain traction, fears of deflation were starting to take root, and terrorism risk was on the front of investors’ minds. Amidst this backdrop, the emotional reaction was to get defensive. But the rational reaction was to look at valuations and recognize that the market was already pricing in what seemed to be an unreasonably high level of risk. In sticking to our valuation discipline, we maintained our equity exposure and were rewarded, with the S&P 500 gaining almost 52% since it bottomed on March 11, 2003.
Some of the same big-picture risks from that time continue to impact our thinking today. The structural imbalances in the economy are now among our biggest worries. In particular, the potential of a dollar collapse, and the impact it would have on the rest of the economy, remains a meaningful risk. While we do not think the chances of a dollar collapse are high, the impact would be broadly negative across the world economy. A declining dollar could mean higher interest rates are required to attract the capital to fund our current account deficit. With many consumers already facing high household debt levels, including a lot of variable-rate debt, higher rates could depress spending as consumers lose disposable income to higher debt payments and try to rebuild their balance sheets. It could also take the wind out of the housing market—reducing another positive influence on consumer spending.
This brings us to another concern that factored into our thinking 18 months ago – deflation. The impact of a significant rise in interest rates would likely lead to a falloff in consumer and corporate spending and could result in a debt crisis, which could tip the economy into recession and even deflation. A debt-crisis or dollar-crash scenario would not be great for bonds in general, but stocks would probably do far worse, so bonds would play an important role in reducing losses at the portfolio level. Again, we don’t view these scenarios as likely, but we believe it is important to account for them in how we manage risk in our portfolios.
We don’t mean to paint a depressing scenario for the New Year. What we want to do is remind investors that following a good year, or in this case two good years, it is easy to feel good about the markets and ignore the risks. And following a bad year, or three-plus bad years, as was the case in early 2003, it is easy to overplay the risks (even as cheap valuations provided a big cushion). This inverted perception of risk and reward is what underlies the bulk of the decision errors made by investors. We view our job as ignoring the psychological impact of recent market performance and focusing on the fundamentals, both negative and positive, and there are plenty of positives or offsetting factors as well. For example, the economy is generally healthy with global economic growth near a 30-year high. Productivity growth has been a positive. The U.S. consumer may not be in as bad shape as many think – credit card delinquencies have declined, and household assets have risen thanks to strong home prices. Corporate earnings have been very strong, and most corporations have plenty of cash on their balance sheets, which bodes well for capital spending. Valuations aren’t as good as they were, but are still well within a range we consider fair. So where does that leave us going forward?
Given their strong run, our return expectations for equities have come down. In our base-case three to five-year scenario, we look for equity returns in the upper single digits. However, there are scenarios, such as a dollar crash or a debt crisis, that would likely result in much lower returns. With respect to style, value has been dominant over growth since the bursting of the tech bubble in early 2000. Growth does not, however, have a clear enough valuation advantage to justify an overweighting at this time. Smaller-caps also entered the bubble period with a significant valuation advantage, and have been great performers versus large-caps since 1999. However, by many measures smaller-caps are starting to look a bit pricey.
The Fed is clearly in a slow-and-steady tightening mode, and with a massive budget deficit, bond supply is likely to increase, which should also put some upward pressure on rates. At some point the willingness of foreign governments, particularly in Asia, to add to their Treasury positions will wane, and the resulting reduction in demand could also lead to higher rates. In spite of these relatively poor conditions, higher interest rates also mean higher yields, and our analysis suggests that bond returns should still be in the low single digits on average over the next several years. And as noted, bonds continue to have an important role to play as volatility reducers in the event of a bear market or as protection in the event that we tip back towards deflation. Lastly, there is a real chance that we will see only a modest rise in rates—a significant rise in rates is far from a certainty.
On a statistical basis, foreign stocks continue to look cheap, but not as cheap as they were two years ago. Nevertheless, they are selling at a discount to the US market. Therefore given all the evidence, we continue to over-weight international equities.
With No Fat Pitches, Managers Are Key
Reflecting the lack of compelling opportunities and our big-picture concerns, both of our current tactical plays are based on risk containment rather than pure return potential. We are underweighted to investment-grade bonds in all but our equity portfolios, as we expect rates to move up over the next several years. We also own FPA New Income, which currently has a very short duration. Also on the bond side we have allocations to foreign bonds through both Loomis Sayles Bond and PIMCO Global Bond. Given the lack of return-based fat pitches, our managers are especially important right now as a source of potential outperformance. We feel that over the long-term, the managers we use should be able to beat their benchmarks, but we do not expect that this will be the case every single year.
While we have been fortunate to have a good year once again with respect to our own performance, we remind our clients that this will not always be the case in the short term (as I write this letter the market is down about 3% in the first seven trading days of 2005). But we are confident that by working hard to make well-reasoned investment decisions and staying disciplined we will be able to continue to generate above-average returns over the long term.
As always, we thank you for your confidence.
Jon Houk, CFP®