|We’ve enjoyed strong absolute and relative returns this year after a difficult 2008.We continue to believe that we are in the midst of a major debt-driven transition in the economy that will keep risks elevated, result in continued economic headwinds, and have longer-term consequences due to the buildup of our public (government) debt.
We believe stocks are fair value given the potential weak growth that seems likely in an economy that is deleveraging. Given the changes we have made in the last two quarter we would consider our portfolio’s “neutrally” weighted from a risk standpoint.
Our goal is to wait patiently and then act when we see investment opportunities, which we believe can materially raise portfolio returns over our five-year investment horizon.
Quarterly Investment Commentary
When the dust settled on one of the most eventful and upended years in memory, investors had generous gains in stocks and certain segments of the bond market to salve the wounds of a disastrous 2008 and first quarter of 2009. As I write this letter, I’m somewhat surprised at how accurate an off-hand remark I made at the beginning of the year ended up being. When asked how 2009 would be in the markets, I guessed it would be “up 20% and down 20%.” As it turned out, both of those were true.
Stocks finished the year strongly, continuing their powerful run that began in early March. Large company stocks1 gained about 6% in the final quarter, almost 70% since the bottom in March and finished 2009 with a 26.5% gain. In both the quarter and the full year, growth sharply outpaced value, but between larger companies and smaller, returns were pretty similar.
On the domestic fixed-income side, returns varied widely in 2009. Domestic bonds2 gained about 6% for the year, but intermediate treasuries3 were down -6.4% and investment-grade corporate bonds4 gained more than 14%. High-yield bonds5, which normally exhibit hybrid characteristics of stocks and bonds, instead crushed both gaining over 55% for the year.
Heading overseas, the story was emerging markets. Both equity and debt of emerging-markets countries left their developed-market counterparts in their dust. Emerging markets6 tacked on 8.2% in the fourth quarter to bring its full-year gain to over 75%, versus a gain for developed markets7 of 3.2% for the quarter and a still impressive 37% for the year. For bonds the pattern was tighter but the same: Emerging-markets bonds8 gained 2.8% and 22% for the quarter and year, while developed-nation sovereign bonds9 lost 1.9% in the fourth quarter and gained only 2.6% for the year.
We are pleased to report that our portfolio’s outperformed their benchmarks in the fourth quarter and the full year by considerable margins. The reasons are the strong gains of our tactical positions in large growth stocks, high-yield bonds and both emerging-markets equities and debt combined with strong overall showings from both our active fixed-income and equity managers.
As we’ll elaborate on below, we aren’t overly enthusiastic about the multiyear return potential from either stocks or bonds, but are somewhat optimistic over the short run, because it seems the government will continue to support the economy though whatever means necessary using a variety of stimulus/spending programs. Long term this will create huge problems for the economy and financial markets, but short term it will help.
As we look ahead over the next several years, we believe that the weight of the evidence makes a strong case for a tough road for the economy and the financial markets, despite the beginnings of an economic recovery—which at this point has been mostly government supported. As we normally do in these newsletters we going to start with the negatives first…..but please read the entire letter.
Debt, Debt, and More Debt
We believe that we are in the midst of a major debt-driven transition in the economy that will keep risks elevated, result in continued economic headwinds, and have longer-term consequences due to the acceleration of the buildup of our public (government) debt.
Household Debt: Households have hit a debt wall and are in the process of deleveraging. Despite the huge government stimulus, this process is not close to being over.
Consumer Spending Headwinds: Because consumer spending is 70% of the economy it is hugely important to overall economic growth. The desire among households to rebuild balance sheets, along with high unemployment and low perceived job security, makes it very likely that consumption growth will be subpar compared to what we’ve been used to.
U.S. Government Debt Explosion: The U.S. Government’s actions in aggregate probably saved us from a 1930s-type depression. However, the resulting leap in the government deficit comes at a terrible time. This increase, coupled with a coming explosion of Social Security, Medicare, and Medicaid benefits to retiring baby boomers, means that the U.S. faces extremely challenging times in the coming years.
As debt continues to grow, at some point it will become difficult to get investors to lend to a fiscally challenged U.S. in the amounts needed without paying a significantly higher interest rate. Though some increase in borrowing costs is likely soon, the risk of a sharp increase in rates is not imminent if the recovery is subpar (as seems very likely). But looking out 10 years and beyond, the math is impossible to ignore unless the economy grows at a 4% plus rate. There is little question that taxes will have to increase and spending will have to decrease. If this doesn’t happen in a significant way, and maybe even if it does, there is a great risk of both a dollar and an interest-rate crisis that could be extremely painful for the U.S. and global economies.
There are still many variables in play that relate to these concerns, including a slower than anticipated recovery for the labor market; the wave of upcoming foreclosures and continued high unemployment; small businesses suffering from weak demand and a larger decline in profits than bigger firms; states and municipalities suffering from the steepest decline in tax revenue on record; and loan delinquency rates continuing to increase.
Given the challenges, there is huge risk of policy mistakes as the Fed and the Treasury attempt to maneuver through the next few years. Unwinding of the stimulus at the right time and in the right way will be one of the big challenges. At what point the economy can stand on its own remains an open question, not just in the United States but in most of Europe and Japan as well. As we have stated many times over the last year Government Policy will matter and have a greater impact on our investment decisions then it has in the past.
There are some positives, however. This is the largest global stimulus ever to occur in peace time. Strong emerging-markets economies are feeding back into the global economy, which is a positive for exports and manufacturing. Corporate balance sheets, outside of financials, are in good shape with the best liquidity in 50 years. Inventories are low and a rebuilding cycle is beginning, which will support growth. And, the severity of the economic contraction and corporate cost cutting may mean that businesses overreacted and will need to aggressively increase investment and hiring (not likely in our view).
We don’t dismiss the positives as they explain why some recovery is likely to be sustained. However, we continue to believe that the weight of the evidence makes a strong case for a sustainable but subpar economic recovery very similar the “muddling along” scenario I communicated all of last year.
We assess return potential via scenario analysis that incorporates our assessment of asset-class pricing and fundamentals and how they are likely to be impacted under various economic possibilities (discussed above) over the next five years.
Corporate and high-yield bonds are not overvalued but they are no longer cheap. U.S. government bonds are priced to deliver poor returns over five years, barring a severe deflationary world. With historically low dividend yields of less than 4%, REITs are also overvalued. Only emerging-markets local-currency (non-dollar) bonds look reasonably attractive in most scenarios but even they are subject to a fairly high level of short-term risk stemming from currency fluctuations. In short, no asset class appears priced to generate fabulous returns—though some asset classes will do better than others and there are specific investments that look somewhat attractive. Only in our optimistic scenario are the expected returns for equities above double digits over the next five years. However, we put a lower probability on this optimistic scenario playing out.
Investing requires one to make decisions with incomplete information and therefore uncertain outcomes. For this reason we believe we must have an understanding of the odds and the payoffs. We use our scenario analysis and valuation work to help us play odds maker and understand the upside we gain in exchange for taking risk. Ultimately we want the odds heavily in favor of the decisions we make. But having the odds in our favor does not mean that we will be right immediately or even at all, especially in the short run. But over the long run our discipline, which implicitly requires us to be willing to be wrong in the short run, has added value by putting us in a position to be right far more than we have been wrong.
Given the risks we see, coupled with the return outlook in most scenarios, we must conclude that we do not like the odds nor are we tempted by the potential rewards for taking excess risk, even though we are at the beginning of economic recovery (this the time normally you would take excess risk). Our portfolios are currently what we would consider “neutral” risk, which is unusual at the beginning of an economic recovery, but we think is prudent.
Getting Paid to Wait
Looking out over our five-year window, if we simply invested in equities and bonds and held them without making any tactical moves, we would expect returns to be in the mid-single-digit range. However, though we are long-term investors, this static buy, hold, and simply rebalance approach has never made sense to us. Market swings occasionally give us opportunities to do much better.
Looking forward over the next five years we believe higher returns can be captured by patiently waiting for compelling opportunities and then making tactical moves when they appear. We have a long-term track record of adding value over full market cycles via tactical moves. Especially in a low-return world, this source of added return could be quite material.
As discussed above, we don’t believe stocks are cheap. Moreover, we are headed into a period of increased regulation and taxation which will add to growth headwinds. With respect to bonds, while it is true that rates are low and this will limit returns, much of the non-government bond market (corporate and agency mortgages), while no longer cheap, is priced to deliver mid-single-digit returns over the next few years with far less risk than equities.
For taxable clients/accounts, we are maintaining our tax-exempt bond holdings with slightly longer maturity exposure because yields there are somewhat elevated compared to taxable bonds. Though these bonds are at risk if rates rise, yields are high enough to provide some protection.
Over the last few months we have been doing intensive research on alternative investments to include in our portfolios. The alternative investment market has traditionally been made up of limited partnerships with high minimums, long lockups, limited transparency and high fees and therefore, by and large, we have done very little investing in these investments. However, there are some great opportunities in those products. As you may know, there has been significant change in this area of the market since the Madoff Fraud / Scandal. Now these types of products and strategies are available in the 1940 Act (i.e. mutual fund products) which provides you, the investor, tremendous protections and transparencies that the limited partnerships don’t.
Given our concerns regarding the economy the next five years and given a headwind with the financial markets, it only makes sense to look at opportunities that can give us potential similar returns with less risk. As we go forward in 2010, we expect you will hear more about alternative investments from us and will see them in your portfolios.
We remain strongly committed to focusing everything we do on rewarding you for your confidence that you place with us.
Jon Houk, CFP®
|1Vanguard 500 Index Fund 2Vanguard Total Bond Market Index Fund 3iShares Barclays 7-10 Year Treasury ETF 4iShares Barclays Credit Bond ETF 5Merrill Lynch U.S. High-Yield Cash Pay Index||6Vanguard’s Emerging Market Stock Index Fund 7Vanguard Total International Stock Index 8JPMorgan GBI-EM Global Diversified Index 9Citigroup World Government Bond Index|