|The first six months of 2010 have been a bit of a roller coaster—domestic stocks were up early in the year, then down 5% by early February, then up almost 10% for the year by late April, then down nearly 7% for the year by the end of June. All of our portfolios have outperformed their benchmarks for the year through June 30 as a result of both our tactical positions and of the value added by our active managers.
Our commentary examines the eco-nomic “tug of war” being reflected in the stock market, with improving economic and company fundamentals on the one side, and concerns about debt-related stress points and the longer-term strength of the economic recovery on the other.
Our view of the big-picture envi-ronment we face in the next few years remains unchanged. The recovery continues but it is not inspiring, and we see average risk in spite of being early in a recovery cycle. We are muddling along.
Our investment strategy is base on bottom up valuation work and not a predicting what the Marco eco-nomic conditions will be next year.
Quarterly Investment Commentary
Stocks continued their slide in June, ending the first half of 2010 with losses in every segment of the equity market. The large-cap Vanguard 500 Index lost 11.5% for the quarter, and is down 6.7% year to date. The small-cap iShares Russell 2000 and iShares Russell Midcap both lost 10% in the second quarter, though thanks to a strong first-quarter, both benchmarks are down just 2% year to date. Turning abroad, the story was similarly painful. The Vanguard Total International Stock Index dropped 13.3% in the second quarter, bringing its year-to-date loss to 12%. The Vanguard Emerging Market Stock Index lost over 9% for the quarter and nearly 7% year to date.
Most of the positive news for the first six months of the year was in fixed income. The Vanguard Total Bond Market Index Fund, a proxy for high-quality, intermediate-term bonds, gained 3.6% over the second quarter, and is up 5.3% for the year through June. Foreign bonds were mixed. The Citigroup World Government Bond index was flat in the second quarter, but still down 1% year to date, and although the JPMorgan GBI-EM Global Diversified Index lost 2% for the quarter, it returned a positive 3.4% for the year through June.
All of our portfolios have outperformed their benchmarks for the year through June 30 as a result of both our tactical positions and of the value added by our active managers. In our balanced portfolios, the largest contributor to performance was our tactical allocation to emerging-markets local-currency bonds (ELB). Other tactical positions, such as our hedged equity position also has helped performance. We talk more about our current views and future performance expectations in the commentary below:
As noted in the performance review above, the first six months of 2010 have been a bit of a roller coaster—domestic stocks were up early in the year, then down 5% by early February, then up almost 10% for the year by late April, then down nearly 7% for the year by the end of June. This reflects what we see as an economic “tug of war” in the stock market, with improving economic and company fundamentals on the one side, and concerns about debt-related stress points and the longer-term strength of the economic recovery on the other. The tension between these opposing forces has left investors uncertain and the stock markets stuck in a trading range (i.e., bouncing around within a range with no clear trend). We think that unusually high uncertainty could be with us for years to come because the economic challenges we face are serious and will not be resolved quickly.
The Challenges We Face
It’s no secret that there is too much debt in most of the developed world—the United States, Europe, and Japan. We’ve written about it ad nauseam. That the problem is identified doesn’t lessen the challenge. In coming years the developed world must walk a tightrope as it deals with the pressing need to slow and ultimately reverse debt growth without also seriously harming economic growth rates.
While the private sector gradually de-levers, and we wait for the public sector to later do the same, at least the United States is experiencing an economic recovery, albeit a tepid one. There has been clear improvement from the depths of the recession. The economic cycle is, for now, a plus, but the big problems have not been resolved.
The rest of the developed world looks worse. Europe is experiencing very slow growth, southern Europe is uncompetitive and has many countries in various stages of sovereign debt crisis, and economic policy is a challenge given a single monetary policy in the eurozone, but no political union and differing economic situations.
Fortunately, key parts of the developing world are in much better shape with stronger balance sheets, higher growth rates, younger populations, and slowly emerging consumer sectors. Their strength is an important source of support for the global recovery. And there are other positives that help to mitigate the negatives. The continued impact of massive federal stimulus (though this will wane later this year in the United States), healthy corporate balance sheets and cash flow (after huge cuts to expenses), and a natural rebound in economic activity after a huge decline are also sources of strength in the U.S. and global economy.
Thus, our view of the big-picture environment we face in the next few years remains unchanged. The recovery continues but is not inspiring, and we see above-average risk in spite of being early in a recovery cycle.
Bottom up Valuation and Why We Don’t Do Macro
Before I talk about our current investment position and our view on stocks, bonds, etc., I thought I would take a moment to discuss where our macro viewpoint of the economy comes into our decision making. As a reference, “Macro” is the big picture economics (30,000 foot view) and “Bottom up” is looking at the valuation of an asset class based upon historical valuations. As you know, we do talk about Macro because we need to know where we are and often it provides a background and frame work for our bottom up valuation work and decisions, but you can see from the title of this section it doesn’t affect our decision making much. To explain that, I will reference a quote from John Gailbraith, “one of the greatest pieces of economic wisdom is to know what you do not know” and I’m sure I don’t know what is going to happen in the future.
It would be a huge advantage to be able to consistently and accurately predict various economic variables that drive market performance. Early in my career, as I talked to many well-known investors at large financial institutions and money management firms, I was very impressed with how smart and articulate these experts were. They would explain why specific currencies were going to be strong or weak, or which economic variables were going to provide a tailwind that would lead to the outperformance of certain stock markets. Or they would explain an alarming but convincing gloom-and doom scenario. Others might have a handle on why consumer sentiment would go in the tank, resulting in a recession. After a few years of talking to many investors I developed a frame of reference and a perspective that allowed me to draw some very important insights over the years.
- Though the analysis was often compelling, and sometimes right, ultimately the opinions about the variables that really mattered were often wrong. Their batting average simply wasn’t high enough to make them useful for making investment decisions. Moreover, some very harmful investment mistakes resulted from getting drawn in by compelling macro analysis of economic and/or political factors.
- There are reasons that macro predictions are so difficult, especially at turning points, which is when it matters most. There are many dynamics at work and interrelationships evolve. It’s highly complex even for econometric models. And because it is highly complex, it is easy to over-analyze, but not easy to accurately analyze.
- Even if you get the macro right, there are often more important factors that can have a bigger impact on the investment environment. The disintegration of the Soviet Union and the collapse of the Iron Curtain, Iraq’s invasion of Kuwait in 1990, the tech bubble of the late 1990s, and September 11 and its impact on the geopolitical environment are a few examples.
- It is easier to get the macro right when the forecast is easier to see—but when this happens the information is not helpful because it is already widely understood and largely reflected in the prices of financial assets.
- The investing public and the news media expect major financial institutions to have macro views, and public perception of these institutions is often driven by how smart they sound in offering their expertise about current events. In some cases the incentive to devote resources to this area seems driven by outside expectations, and not necessarily by the belief that it will improve their decision making.
Ultimately we realized the wisdom in focusing on the knowable. We believe that if we get most of our decisions right (a high percentage) we will increase the odds of adding value (risk-adjusted return) versus our benchmarks. We believe we will be right a higher percentage of the time if we are intellectually honest and make decisions in those areas where we believe we have expertise and our decision is based on something we know, or on an opinion in which we have sound reasons to feel highly confident. This is why we focus on asset-class valuations and manager due diligence, which we believe are much easier to assess than top-down economic or political factors.
For example, our small-cap exposure is mostly driven by our valuation analysis, but is also influenced by whether or not the economic cycle is early or mature. This is an example of how today, valuation trumps macro. Given the fact that we are early in an economic cycle, macro would tell us to invest heavily in Small Caps as we did coming out of the 2002 recession, but our valuation analysis tells us that Small Caps are expensive relative to Large Caps therefore we have limited Small Cap exposure in our portfolios.
Capturing Returns and Protecting Capital—Our Investment Posture
Stocks: After a huge stock rebound from the market depths of March 2009, our equity scenario analysis continues to suggest that developed stock markets offer only mid-single-digit return potential over the next five years. On the positive side, we continue to have some optimism that the low-return environment we think is likely may be a good one for highly skilled active managers to add value over their benchmarks.
Bonds: Within our bond allocation, while high quality investment-grade bonds only offer minimal return potential over our five-year horizon, they do offer a defensive investment (insurance) that could perform well if the economy is very weak or falls back into recession. Additionally, the fixed-income vehicles we hold are more aggressive and potentially more volatile than a typical investment-grade bond portfolio, as we believe these fixed-income positions will capture materially higher returns and provide much better protection against unexpected inflation and in a rising rate environment.
Among the fixed-income asset classes, we still find emerging-markets local-currency bonds to be the most compelling from an expected risk/return standpoint, though we don’t expect returns to be excitingly high. Potential ELB return comes from the interest income and our expectation that the economic fundamentals (less debt and more growth) in many key developing economies are very likely to lead to currency appreciation (versus the dollar) over a multiyear time frame. In all but our most pessimistic scenario we expect returns from the ELB asset class to range from the mid- to high single-digits, possibly even into the low double-digits. Moreover we view this asset class as significantly less risky than equities. However, it is much more volatile over the short run than investment-grade bonds and we don’t view it as a defensive asset class—rather, we view it as a hybrid when we assess its impact on our overall portfolio level risk.
Alternative Investments: After a concerted research effort, we are going to be adding alternative investments this coming quarter. There will be two distinct pieces. The first will be equity hedged investments whose goal is to participate in the equity markets on the upside, but also be protected on the down side. The second part will be alternative funds that will very little or no correlation to stocks or bonds. The investments will be funded by reducing our equity positions and by selling all of our remaining high-yield bond positions—effectively closing out the last of a tactical asset-class move that was one of the most successful in our 23-year history.
Assessing five-year return expectations is a critical step in our investment process; however, so is our portfolio-level risk analysis. This step involves assessing how each portfolio is likely to perform in various one-year risk scenarios, then using this information to further calibrate the exposure to various asset classes. This process, along with our individual asset class analysis, will result in our portfolios being underweight to equities and therefore somewhat conservatively postured. We believe we are positioned to perform better than benchmarks in a bear market or a low-return market. However, if stocks have a strong upward move, our portfolios are almost certain to lag their benchmark returns.
Though we recognize a positive investment scenario is possible, as is a temporary period of strong market performance that could be driven by improving economic news and impatience with the near zero return offered by the money markets, we are clearly not placing a high probability on a bullish environment. For some time now, our view of the opportunities and risks for investors hasn’t been very encouraging. And while the story is what it is, it is also important to remember it won’t last forever—there will be better opportunities at some point. We hope that some of those opportunities will come soon and allow us to perform better than what the broader markets give us. But we’re prepared to be patient. In the meantime we are working hard to ensure that when opportunities do present themselves we are in a position to recognize and take advantage of them, while also being highly attuned to the potential risks in this uncertain environment.
We remain strongly committed to focusing everything we do on rewarding you for your confidence.
Jon Houk, CFP®