September 2007
Monthly Investment Commentary | September 2007
Growth has outpaced value across the market spectrum, by modest margins in August, and by larger margins for the first eight months of 2007. Foreign stocks, as represented by Vanguard Total International Stock Index Fund, lost 0.7% in August. The volatility in stocks drove demand for higher-quality bonds. Domestically, intermediate-term, investment-grade bonds gained 1.3% in August, while Salomon Brothers World Government Bond Index was up 1.6%. Short-term, local-currency, emerging-market bonds were down 0.4%—not a great showing in absolute terms, but good enough in a risk-averse environment to help validate the benefit of their short maturities and high credit quality. REITs rebounded sharply for the month, but still show near-double-digit losses year to date. Research Team Q&AThe recent turmoil in the markets has generated many questions from subscribers. We address these in the Q&A that follows. Why didn’t you and others see the credit crunch coming? Many people have been aware of the potential dangers associated with the housing bubble and increased risk appetites as investors reached for better returns. The danger was reflected in tiny credit spreads (between high- and low-quality debt), increased leverage (including the carry trade), and the easiest lending standards of all time. We have written about these developments in our investment commentaries and there have been various levels of concern within the industry. We have been aware that the unwinding of leverage was a risk. We also worried about a slowdown in the housing market though over the past year, third-party research we’ve reviewed led us to become somewhat less concerned that a housing slowdown, by itself, would cause a recession. What we didn’t know about these risks was when they might play out (they have been with us for quite a while) and how bad they might turn out to be. We weighed the unknowns against other positive factors, including the strength of the global economy and, most importantly, what we believe are quite reasonable equity market valuations. Our study of past equity bear markets suggests that very bad bear markets usually occur when there is a confluence of negative factors. Over-valuation in the equity markets is almost always one of the factors—and this is not the case today in our opinion. So far, the size of the equity correction has not been alarming—stocks were down 10% at their worst. There have been 87 10% declines in the S&P 500 over the past 80 years. That amounts to slightly more than one per year on average—so a decline of this magnitude has not been rare, though we have not experienced one for quite a while. Remember that our portfolios are built to take into account the possibility of various negative scenarios and maximum 12-month loss thresholds in each portfolio. If the market starts declining again, it will take a sizable decline to cause us to violate our loss thresholds. This is because our portfolios are not, in our opinion, aggressively postured. Risk is close to neutral. Of course, it is important to remember that we manage risk based on a one-year horizon; over periods shorter than one year our portfolios could perform worse. The problem is that predicting where the market will be in a matter of months is essentially a gamble. We’ve learned over the years that markets have a tendency to surprise investors and it is dangerous to get caught up in optimism or pessimism when making decisions. This is why we believe it is sensible to focus on: 1) valuations, which we believe are the primary driver of returns over the long run and are the factor we can most confidently assess, and 2) the inherent risk in each portfolio based on our assessment of the risk in each asset class under various negative scenarios. If this correction is over, then it clearly would not have made sense to scale back risk when we first began worrying about the risks (as we write this, stocks are still up over 1.7% on the year)—we would have given up too much return in order to provide a greater amount of capital protection than our portfolios call for. During this recent market turmoil, my impression is that asset classes such as domestic and foreign stocks, unhedged foreign bonds, and commodities were positively correlated with each other, reducing their diversification benefit. Is this the case, and has it changed your view of how your model portfolios are constructed? Many risk-oriented asset classes show a positive correlation, and this was the case during the recent decline. U.S. and foreign equity benchmarks covering all styles and market caps declined from the July 19 S&P 500 peak through the August 15 trough (which is the low point as of this writing; most equity asset classes have since rebounded somewhat). Generally, growth did a bit better than value, large-cap did a bit better than small-cap, and U.S. did better than foreign. REITs did worst of all, continuing the slide they have been experiencing. Commodity futures also declined but less so than equities (PIMCO’s fund was down 3%)—this was a mild disappointment but not overly surprising given the concerns about recession. Investment-grade bonds were positive. PTTRX and PIMCO Foreign Bond Unhedged were both up just over 1%. Short-term emerging markets local currency bonds declined in value as the dollar strengthened against these currencies (PIMCO’s fund was down 4%). As we write this most of the equity asset classes have recouped some of their losses. In terms of how asset classes behaved during this market upheaval, there were no big surprises and nothing that would lead us to rethink the assumptions we make in determining portfolio allocations with respect to our loss thresholds. Here is a brief summary of our general expectations about asset class behavior:
The bottom line is that the events of the past month have not changed our view of how portfolios should be constructed. There have not been major surprises with respect to asset class behavior. We have known that we have an above-neutral level of recession risk in our balanced portfolios because of our commodity exposure, local developing markets exposure, and Loomis Sayles Bond exposure (which has some junk bond and emerging markets currency positions). We have stress tested each portfolio assuming very negative scenarios and performance still does not violate the stated risk tolerances. Of course our stress testing is theoretical so we can never be sure that things will play out as we believe. It is possible we may rethink some of this exposure based on our view of the business cycle and recession risk. At this moment we are still comfortable with our current positions. We received several questions about the risk of a recession. Recession risk has increased. The already-struggling housing sector coupled with the credit squeeze has increased the risk that spending activity could be sharply curtailed. A lot may depend on how long it takes for credit markets to return to normal. We’ve gone from a debt bubble, where borrowing was far too easy, to the opposite. A normal environment is between these two extremes. We are not economists and we are unwilling to bet too heavily on any macro view. With that caveat, our sense from reviewing research from firms we respect is that the combination of strength in the global economy, the amount of capital that is in the global system, and the Fed’s willingness to aggressively ease if necessary, makes a recession somewhat unlikely in the near term. However, the impact of the credit squeeze is not yet reflected in the numbers, the housing market outlook remains bad, and it seems likely that other blow-ups (hedge funds, mortgage companies, derivatives, asset markdowns, etc.) will rise to the surface, temporarily undermining investor confidence. So while a recession is still not the most likely case in the near term, some economic slowdown seems very likely and the risk of recession has risen. Given the way the markets have responded to prior stock market plunges in 1987 and especially 1998, what is your outlook for the next couple of months in terms of the broad U.S. market? We are never comfortable forecasting the market over a couple of months. Even in more-stable environments, market sentiment can change quickly, driven by any one of a number of factors (economic, political, environmental, terrorism, etc.). So far the Fed’s move seems to have stabilized the stock market. Mortgage rates are declining. But there is still clearly nervousness in the markets. There has been no rebound in housing stocks and Countrywide Financial, a bellwether of the current credit squeeze, while off its lows, has not moved much despite several positive developments including a $2 billion equity-based liquidity infusion from Bank of America. Because there is much we can’t know, our decisions focus on long-term asset class valuation relationships, portfolio level risk assessment, and scenario analysis. These factors allow us to make decisions we believe are well founded from a multi-year standpoint, while maintaining a high probability of managing one-year risk consistent with stated risk tolerances. It seems to me that we are getting closer to when Loomis Sayles Bond should not be a part of the portfolios. Creditworthiness is weakening and corporation strength might also weaken as the inevitable journey towards recession continues. I believe that rising interest rates have not caused a problem, but I fear that choppy waters are nearing on LSBDX. I would be interested on your perspective. We tend to view our Loomis Sayles Bond position as a long-term strategic position. While we are aware that we are taking on more risk (i.e., volatility and potential downside) with this fund than a typical core investment-grade bond fund such as PIMCO Total Return, we also strongly believe that over the long-term we are getting paid an excess return for assuming this shorter-term risk. We have been investors in this fund in our models for well over a decade, and despite some down cycles, the fund has added significant value relative to both its custom benchmark and bond fund peers during this time. We continue to believe that Dan Fuss is one of the best bond fund managers and investment thinkers in the business, and that Loomis’ fixed-income team is deep and talented. So our bias is not to try to time entry and exit points for the fund. Moreover, when we “stress test” our model portfolios under various scenarios, we account for Loomis Bond’s significant exposure to junk bonds and foreign/emerging-market currencies and the fact that it will lag a more conservative/higher-quality bond fund in certain scenarios, e.g., a U.S. recession where the dollar is either strengthening or neutral versus other currencies. In our base case scenario, we continue to believe Loomis Bond will outperform the investment-grade bond index (and PIMCO Total Return) by a modest margin over a five-year time horizon. In scenarios involving a depreciating dollar, the outperformance could be quite large (as it has been in recent years). Therefore, since we believe that over a five-plus-year time frame we will earn better returns from Loomis than, say PTTRX, and, since we have factored the higher downside risk from Loomis into our overall portfolio construction, in order for us to decide to reduce our exposure to Loomis and increase exposure to a more conservative bond fund we would need to have conviction that a severe recession and/or strong dollar scenario is very likely to play out within the next few years. At this time we are not there. Alternatively, for example, if we came to the conclusion that U.S. equities were a fat pitch and we wanted to overweight them, we would consider funding some/all of the overweighting from our Loomis Bond position. Again, we are not there. We received several questions about asset classes and fat pitches, and these are aggregated into a single response. So far, the recent market turmoil has not created any opportunities that meet our fat-pitch criteria. Other than REITs (which have been declining for months), no asset classes have been hit all that hard. International stocks have experienced fairly sizable declines but part of that has been a strengthening of the dollar against most currencies except for the yen. Here is a quick summary of asset classes:
Although Thornburg Mortgage is a separate business from Thornburg Investment Management, has the news about asset liquidations affected your position on this or any other Thornburg mutual fund? Not at all. We have received a number of questions about PIMCO Developing Local Markets (PLMIX), the answers to which are aggregated below. We are seeing an increase in risk aversion in general, which is leading to a “flight to safety,” i.e., investors are looking to invest in instruments and/or assets that they perceive to be safe, such as U.S. Treasuries. Some of this is driven by some unwinding in the “carry trade” (borrowing in yen at low interest rates and investing in higher-yielding instruments). PLMIX’s losses are due to emerging-market currencies declining versus the U.S. dollar. For example, between July 19 and August 15, the Brazilian real and the Polish zloty, two of the fund’s larger positions, were down over 5% and 3%, respectively. This is not a surprise because emerging markets, despite their fundamental improvements, are perceived to be riskier and in periods of heightened risk aversion we expect PLMIX to decline over the short term as investors move their capital to what they perceive as safer securities. And as mentioned, there is strong evidence of some unwinding in the carry trade which has resulted in sharp appreciation in the yen and depreciation in a number of emerging-markets currencies (but as we write this, emerging markets currencies have been rebounding strongly in the past few days). Longer term we believe emerging-market fundamentals, such as current-account surpluses, large foreign-exchange reserves, and superior growth versus developed markets, will be important to investors, and we continue to believe that PLMIX is a good way to benefit from a gradual but significant decline in the U.S. dollar. This is a good time to revisit the risks we take on by investing in PLMIX and the reasons we continue to hold it in our balanced models. Currency risk is the primary risk that impacts the fund. PLMIX takes minimal interest-rate risk (currently its duration is 0.9 years). However, as mentioned above we believe over the long run currency will be a positive. But if we (and others) are being overly optimistic about emerging-markets fundamentals, then currencies could weaken. Because it invests in local debt and money-market-type instruments of emerging-market governments, the fund is also subject to sovereign risk, i.e., risk a foreign government takes actions that result in a loss of value. This could also, in turn, impact the currency. (Sovereign risk affects the creditworthiness of government debt the same way a corporation’s financial standing affects the creditworthiness of its corporate debt. The fund’s average quality rating is a high A+, with only about 25% of its portfolio in securities rated below A and none below B.) PIMCO estimates the fund’s annual yield to be about 6.5%, gross of expenses, which cushions the impact of currency declines on the fund’s total return to some degree. Also, we believe emerging markets’ improved fundamentals and PLMIX’s diversification across different emerging-market regions will limit its downside over 12 months in most negative scenarios. PLMIX may not be a good hedge in a U.S. dollar crash scenario. In this scenario, we may see increased risk aversion (like we see now, though for different reasons) and it is possible that investors will prefer the safety of developed-market currencies, such as the pound and the euro. However, we consider the dollar-crash scenario to be unlikely because it is in no country’s interest (most countries still have large dollar reserves) so major central banks across the world will have a strong incentive to intervene to prevent it from occurring. Our thinking on PLMIX’s role in our balanced models has not changed. Significant imbalances in the U.S. economy (such as a high current-account deficit) as well as stronger economic growth elsewhere suggest that longer term the dollar is likely to depreciate, and we think exposure to emerging-market currencies is the best way to hedge this intermediate to long-term risk. In addition to providing this non-dollar currency diversification benefit, PLMIX has an attractive long-term return profile, which is a function of its yield, potential for currency appreciation, and our belief in PIMCO’s ability to add value through actively managing the fund. We received several questions on floating rate bond funds, including specific questions about PIMCO’s fund and Eaton Vance’s fund. After our initial research a few years back, we concluded that we were unlikely to use these types of funds in our portfolios, and as a result we have not done extensive research on this category of funds. Though they have some attractive features, in most scenarios they would be trumped by other types of fixed-income alternatives. One of the main characteristics of this category of funds is exposure to high-yield credits, primarily bank loans. For example, Eaton Vance Floating Rate I (EIBLX) almost exclusively owns bank loans and has a small amount of foreign market exposure. PIMCO Floating Rate Income (PFUIX) is really a different animal from most of the funds in this category with sizable exposure to emerging markets and much higher overall credit quality. It is not primarily a bank loan fund. The other primary characteristic of all these funds is low duration. Consider these funds in the following scenarios:
One misnomer is that these funds are alternatives to money market funds. They clearly are not. What is your take on “moral hazard” in the context of the lending crisis? Moral hazard has been a concern for years. It generally refers to investor bailouts by government entities. However, the term is often used specifically with respect to the Fed’s willingness to bail out investors by aggressively lowering interest rates in a crisis that threatens the economy or financial system. Previously called the “Greenspan Put,” the assumption of Fed support may encourage excessive risk taking and leverage. Some think that the longer-term ramifications are imbalances that continue to expand because they are never fully purged from the system, so that more and more debt is piled on in each cycle. The worry is that eventually these imbalances (e.g., excessive consumption, debt, trade deficit, mismatched liabilities, etc.) will have to be reined in, and the further the day of reckoning is pushed into the future, the uglier it will be. So far the actions of the Fed in this crisis have been mostly symbolic. An ultimate day of reckoning is a worry. But frankly we don’t think about it too much. We try to assess the potential cyclical and secular risks at any point in time and factor them into our scenario analysis. However, we don’t factor in 100-year-flood type risks because they would cause portfolios to be exceedingly risk averse for decades, significantly lowering long-term returns. In these environments we would likely experience losses that exceed our portfolio risk targets, but we think the diversification we employ to keep us within our loss thresholds in non-extreme environments would mitigate the severity of losses in this kind of rare disaster scenario. We also think the return prospects following such an environment would be very strong. — 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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Fear and uncertainty surrounding the subprime-driven lending crisis sparked continued market volatility in August. Stocks began the month by rebounding from the sharp sell-off that marked the second half of July, before experiencing another round of sharp declines. Fed moves to provide liquidity (including a cut in its overnight lending rate) helped stabilize markets and stocks wound up finishing the month in the black. Large-cap stocks, as measured by the S&P 500 (Vanguard 500 Index Fund) gained 1.5%. Small-caps saw better gains—the Russell 2000 was up 2.3%—but still trail large-caps by a significant margin year to date.