February 2008
Monthly Investment Commentary | February 2008
Investment Strategy Update The significant recent declines in the stock market reflect investors’ growing fear that a recession may be imminent. Many investors are wondering if it makes sense to become more defensive to avoid any further volatility and potentially further declines in stock prices. Others are wondering about when the declines might lead to compelling investment opportunities being created. Our perspective on the current market environment is most relevant when considered in light of how we manage money, so first we want to remind our readers about several of the basic principles of our investment approach. One is that in the short term, markets can be driven by emotions like greed on the upside and fear on the downside (right now markets are clearly driven by fear). But because short-term drivers of emotion are inherently difficult to predict, it is impractical to base an investment strategy on doing so. Fortunately, it is not as difficult to analyze longer-term business and economic fundamentals with more confidence, and history has demonstrated that fundamentals and stock prices will converge over time. By basing a strategy on longer-term fundamentals and valuations, we can look beyond short-term market declines that might trigger some investors to become defensive at inopportune times. In some asset classes, short-term declines can become significant enough to create a compelling buying opportunity that increases our odds of outperforming our benchmarks over the long term. Meanwhile, another core aspect of our approach is risk management. It is also important to know each client’s financial and psychological capacity to assume risk, and so we also have 12-month loss thresholds for all of our client portfolios, based on various risk profiles. While we can never make guarantees, we can say that we manage our portfolios in a way that we think makes it unlikely that we will violate these loss thresholds. But when markets decline sharply, we realize that it can be difficult for investors to prevent fear from driving their investment decisions—even if their portfolio is not exceeding the maximum loss they understood could occur. Given the recent stock market sell-off, by many simple price-to-earnings measures stocks now look cheap. The problem is that most valuation metrics are based, partly or mostly, on what companies have already earned rather than on what they will earn going forward. Slower earnings growth going forward, or an outright decline in earnings (an earnings recession) would mean stocks are not as attractively valued. As we’ve been pointing out for quite some time, profit margins have been extremely high relative to history, resulting in earnings that are way above their long-term historical trend. In the past when earnings spiked above trend they have always come back at least to trend, and in many cases, have temporarily gone below trend. This strongly suggests that currently, the earnings numbers used to measure valuations are unrealistically high, and the resulting valuation measures are misleading. So how do we assess valuation for the market given the earnings uncertainty? One way is to assume that earnings fall back to trend over our five-year investment horizon. If that happens, and if at that point in time the market is selling at what we would consider to be fair value, then the implied return for stocks from today’s level is in the high single-digit to low double-digit range per year based on our valuation model. That suggests that the market decline we’ve experienced has taken stocks back to a fair-value level—one where earnings revert to their long-term trend. We think this is a reasonable expectation, but it does not warrant a tactical overweighting to stocks in our balanced portfolios. Moreover, other reasonable earnings and valuation scenarios suggest potential five-year annualized returns in only the mid single digits. Therefore, we would want a bigger market decline before we would move to an overweighted position. (All else equal, as current prices decline, potential future returns improve.) If earnings don’t revert all the way back to trend in five years, stock returns would be higher (assuming the same metrics listed above) over this period, but we aren’t willing to bet on this. No doubt many investors are increasingly concerned about recession and are now reducing equity exposure below their normal targets. But recognizing the economic weakness as it becomes apparent is the easy part. Identifying it before the market recognizes it and fully discounts it is far more difficult, yet this is the only way that reducing equity exposure will actually add value. In fact, predicting the timing of recessions with respect to the stock market is very difficult and attempting to do so often detracts from long-term performance. If we believed that the stock market was not discounting a level of earnings weakness we thought was likely over our five-year horizon, we would underweight stocks. But right now, we remain at a neutral stock allocation primarily because we don’t view stocks as expensive and the sell-off we have seen is already discounting a lot of economic weakness. If we are in the midst of an earnings recession, stocks are already discounting some damage. Whether they are adequately discounting the potential near-term earnings decline requires a level of forecasting accuracy that can’t be done with confidence. However, as noted above, our earnings-trend work suggests that prices are roughly in line with where they should be if we assume a reversion to a historically normal level of long-term earnings growth. Moreover, stocks have already fallen quite a bit from their peak (roughly 13% at the time of writing), and in most previous cycles, patient investors who buy after declines of this magnitude do well over the multi-year period that follows. We noted in our recent commentaries that we have a little less of a pure recession hedge in our balanced portfolios than we would if we were at our neutral allocations. This is because our positions in commodity futures and emerging-markets short-term local-currency bonds are funded from a reduction in our domestic investment-grade bonds, which provide a more reliable recession hedge. (We note, however, that commodity futures have performed positively so far this year and over the past three months despite growing recession fears.) In addition, one of the bond funds we own (Loomis Sayles) is not as defensively postured as our core investment-grade fund (PIMCO). It is possible that this could lead to a period of moderate underperformance relative to our benchmarks if the U.S. recession leads to significant overall global weakness or a global recession. But if emerging markets hold up reasonably well (as PIMCO and others expect) then our tactical positions are more likely to add value. Moreover, there are powerful macroeconomic forces at play that support these asset classes (which we’ve written about in previous commentaries). We are willing to keep these tactical allocations even though we realize that we may be giving up some of our recession hedge because, based on our scenario analysis, we believe our long-term performance will be better, and we do not think we are likely to violate our loss thresholds. As the market environment unfolds, we will continue to re-analyze valuations in light of a range of possible economic scenarios that we think could occur, to help us identify at what point we would want to overweight stocks in our balanced portfolios. We have not yet reached that point, but given the level of emotion in the market and the magnitude of declines we’ve already seen, it is possible that it could happen quickly. With bond yields very low, the gap in longer-term return potential between stocks and bonds is already wide. So we may be fairly close, both from the standpoint of time and market levels, to an initial entry point. On the other hand, the thought of reaching those levels obviously highlights the possibility that we could see further declines in the stock market in coming weeks and months. In fact, we wouldn’t be at all surprised to see further declines in the near term as the fallout from the popping of the housing “bubble” and subprime-lending debacle continues. Further, if we do overweight stocks on the basis that further declines create a compelling long-term return opportunity relative to bonds, we will probably be early, since calling a bottom is not something that can be done except through luck. As painful as this would be in the short term, it would set up long-term investors in our balanced portfolios to capture higher returns by holding a higher equity allocation prior to the start of a new market cycle. Unfortunately, we can’t say with confidence what the coming months hold for the economy or the stock market. We are confident, however, that by maintaining our investment discipline and focusing on a multi-year time horizon—including taking advantage of any opportunities that are presented to us—we improve the odds that we will beat our benchmarks over the long term. As always, we are watchful for these opportunities. Research Q&A We regularly use a Q&A format to address questions about our investment views and current strategy. The Q&A format has the advantages of letting us address questions individually without worrying about being limited by a particular theme or subject, and allows readers to focus on areas that are of concern or interest to them. With a recession more likely, will you be building in more defensiveness in your balanced portfolios? Although we agree that the risk of recession has increased over the past several months—the economy may now even be in a recession—we are not making any changes to our portfolios at the moment. We remain at a neutral equity weighting, with an overweight to large-cap stocks and an underweight to small cap. In evaluating an investment or an asset class we always want to look at two things: 1) the underlying economic fundamentals, and 2) what is being discounted in the asset’s current price. Economic fundamentals have deteriorated: earnings are down, unemployment is up, housing remains in a deep slump, financial companies continue huge write-offs. More broadly, we are coming off a period when profit margins and earnings growth are well above their long-term historical averages. As margins come back towards normal, earnings growth for the S&P 500 will likely be subpar. But our valuation analysis indicates that large-cap stocks are reasonably valued. They certainly are not at bargain prices, but nor are they overvalued except on very negative assumptions. The market has already moved down more than 13% from its high in early October 2007, so it is already discounting a material slowdown in earnings. In terms of fundamentals, there are some positives besides all the risks and worries we read about every day in the papers:
The bottom line for us is that we think forecasting recessions and economic recoveries is a loser’s game and cannot be done with enough precision and consistency to serve as the basis for successful investment decisions. Moreover, we know that the stock market is a discounting mechanism – the market typically bottoms out well before (5 to 6 months) the economy shows signs of coming out of a recession. By the time the recession is over, stocks are typically well off their lows. However, that does not mean we ignore what is going on in the economy and the risks that are out there. For example, we are paying a lot of attention to the unfolding credit crisis and the unknowns and risks that may still be lurking there. We don’t think we are viewing it through rose-colored glasses—we are reading a variety of opinions and analysis, some of it very negative—but we are also not willing to forecast a doomsday scenario. We are always balancing potential risk and return in our portfolios. As long-term investors we try to assess the potential returns from each asset class over a five-year horizon. On that basis, we continue to believe equities will beat bonds or cash. But we balance that longer-term return outlook with our 12-month downside risk thresholds. We run a variety of scenario analyses to test the downside risk of the portfolios in different market environments. Our portfolio allocations reflect the outcome of these analyses. As long as we believe the stock market is not discounting an overly optimistic scenario, i.e., as long as valuations are not too high under a variety of reasonable scenarios – and with bond returns looking lackluster due to current low yields – we will likely remain at our current neutral weighting to equities. That said, we recognize that the possibility of a rough year for stocks lies ahead. If we see a sufficiently severe sell-off, we expect to see tactical opportunities created in several asset classes (such as equities, REITs, or high-yield bonds) and these would set us up to earn much better returns going forward. Have you ever looked into investments to profit from currency swings? We have had exposure to foreign bonds in our portfolios since December 2003. We started with PIMCO Foreign Bond and then switched into PIMCO Developing Local Markets in late 2005, soon after it was launched. This non-dollar fixed-income exposure has helped our performance as the dollar has depreciated against both developed and emerging markets currencies over the past four years. We continue to believe the dollar has further to fall against emerging-markets currencies and we like having PIMCO’s portfolio expertise managing our exposure in the DLM fund. The question asks specifically about investments that can profit from “currency swings.” Taking this question literally, the answer is that we have not looked at any investments that would benefit from currency volatility per se. There is one relatively new currency product, Morgan Stanley FX Alpha Strategy Portfolios, that we may do at least initial research on. It is a quantitative-driven, absolute-return strategy using currency forward contracts, with a downside risk target of no more than 2.5% in any 12-month period. The goal is to generate consistent risk-adjusted returns that are uncorrelated to equity and fixed-income market returns or to the direction of the U.S. dollar, but not specifically to profit from currency swings. Will you be changing or reducing your tactical allocation to large-caps over small-caps any time soon? Things can change quickly in the markets, but right now we have no plans to change our tactical overweighting to large-caps over small-caps any time soon. Large-cap valuations still look attractive relative to small-caps and we still believe the potential returns for large-caps are more attractive than small caps. Until small-caps become undervalued relative to large-caps, which could take several years, we expect to maintain our large-cap overweighting. Plus, we believe large-caps should provide at least modestly better downside protection amidst an economic slowdown, whether severe or mild, as they historically have done. The decline of the dollar and stronger overseas growth is also a boost to large-caps, which as a group have a larger share of their earnings coming from business overseas than small-cap companies. Finally, last year, was the first year since 1999 in which large-caps significantly outperformed small-caps. Historically, asset class relative performance cycles don’t tend to last only a year or two. Do you think commodities are played out? If not, do you have any consideration in using PCRDX in the equity/equity-tilted models? To clarify, we do include commodity futures in three out of our four model portfolios. We have a 3% weighting in the Conservative Balanced, Balanced and Equity-Tilted Balanced portfolios, but they are not included in our Equity portfolio. The latter includes no bonds, and the positions in commodity futures are funded from a reduction in investment-grade bonds. We added commodity futures to our balanced portfolios in February 2005, and at the time, we decided against adding them to our all-equity portfolios because the expected pre-tax returns were not clearly superior to equities in a base-case scenario. That, in our view, is still the case, so we do not have any plans to add commodity futures to the all-equity model. To answer your question about whether or not they are played out, we still view them as having long-term benefits for our portfolios. If you recall, last year we determined that commodity futures should be viewed in a longer-term context and we were likely to hold commodity futures beyond our typical 3- to 5-year time horizon for tactical plays. We believe that commodity futures have diversification benefits for balanced portfolios and that they can generate strong long-term returns. In hindsight, of course, we’re glad we made that decision because the Dow Jones AIG Commodity Index was up 16% last year and that certainly helped our balanced portfolios. Longer-term, we are also in the midst of revisiting our strategic, neutral allocations and one of the questions we’ll be considering is whether or not commodity futures have a place in our neutral portfolios. It’s also worth noting that even if we decide they do have a place in our neutral portfolios, that doesn’t mean we won’t underweight them or eliminate them completely if there is a tactical fat pitch that looks more attractive. How close are REITs to being a fat pitch? After beating the broader equity market for seven consecutive years, REITs were down 15% in 2007, underperforming the S&P 500 by 20 percentage points. And this year REITs got off to a rough start early before bouncing back in late January. From their peak in early February of 2007 through the end of January, REITs have declined 26%. Along the way, we’ve followed the asset class closely so that we can identify the point at which valuation levels create a tactical opportunity for us. Our research suggests that fundamentals remain healthy. Balance sheets are strong, occupancies are in the mid to upper 90% across property types, cash flows are still good (which means that dividends are pretty secure), and a very important point is that new construction remains modest, which creates favorable supply/demand dynamics. The big issue right now is the lack of transactions in the property marketplace. The anticipation of declining property values in combination with tighter lending standards has really put a freeze on transaction volumes resulting in wide bid-ask spreads at the property level. Sellers don’t want to accept the drop in prices implied by the changing financing market, while buyers now have a higher return threshold. So there’s an impasse in the property investment market right now, making it tough to get a sense for what will happen to property values. It’s hard to know when transactions will pick up. The CMBS market, which is the biggest source of lending for commercial real estate transactions, has virtually shut down. There’s a lot of discussion around the timing of the re-opening of the refinancing market, but no one knows for sure. Most people are guessing a year or two, which means that it could be a while before we know where property pricing ultimately finds its equilibrium. There are a handful of forced sellers from those who had short-term debt come due and cannot refinance in the current market environment. This will cause transactions to occur, giving us some pricing data. But we would suggest that while the sales from distressed buyers give us some level of price discovery, the question is whether this is where cap rates should be in the long run. We’d say probably not. Just as they were probably too expensive in February 2007, these properties are probably too cheap. While property values will likely weaken over time, the magnitude of this weakness is the big question mark. The public market seems to be anticipating meaningful declines in private market value (or NAVs) and have knocked stocks down. Right now, REITs are trading at a 25% to 30% discount to NAV, which is cheaper than they were in the property bear market in the late 1990s. (REITs have historically traded at a 7% premium.) Our take is that the big discount we’re seeing is based on what we call “unadjusted” NAVs, and reflects property values from early to mid 2007, when transactions and financing were plentiful. If property values decline when transactions pick up (as seems likely), the discount to NAV will decline or possibly disappear. REITs are not as attractive as they currently appear. Meanwhile, other metrics, such as Price/Adjusted Funds from Operations, suggest that REITs are fairly valued to slightly expensive. We’re looking closely at REITs. We’re trying to assess how far NAVs could decline, and determining what the trigger point would be for us to get back into the asset class. There are two parts to this second question. One part is getting a solid handle on the return expectations for REITs, and the other is to compare the risk/reward against other asset classes. Relative yields are an important part of this analysis. Again, this is something we’re giving a good amount of attention to. For now we don’t view REITs as a fat pitch and a tactical allocation to REITs is not imminent — Stapp Financial Planning, PLLC This information is also available at www.stappfinancial.com, or you can download a PDF version. If you do not want to receive future e-mail newsletters from Stapp Financial, link to our subscription form, or send an e-mail to bstapp@stappfinancial.com. Before acting on any advice it is recommended to seek appropriate counsel applicable to your individual circumstances. |
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Equity asset classes around the globe took a drubbing in January. In many ways, asset-class performance lined up as one might expect in a market downturn, with larger-caps losing less than smaller-caps, value down less than growth, and bonds performing strongly. Domestically, the large-cap S&P 500 (represented by Vanguard 500 Index Fund) was down 6%, the Russell Midcap iShares was off by 6.5%, and the Russell 2000 iShares was down 6.8%. Foreign equities, as measured by Vanguard Total International Stock Index Fund, fell by 8.6%. While foreign equities reacted to fear that the U.S. slowdown would affect the rest of the globe, commodity futures told a different story. Their 4.2% gain reflects the expectation that global demand for many commodities will hold up (most of that gain came from commodity futures rather than collateral). PIMCO Commodity RealReturn, which we use for commodity futures exposure, was up 8.3%, with the extra performance mostly generated from its very strong-performing collateral investment in TIPS. Domestic high-quality bonds gained 1.7% in January, while emerging-market short-term local-currency bonds gained 1.4%. Credit quality concerns affected high-yield bonds, which saw spreads widen and the Merrill Lynch High Yield Bond Index fall by 1.3%. REITs had a volatile January, starting off the month by extending their steep slide before rebounding strongly to finish the month down just 0.3%.