Monthly Investment Commentary | September 2008

August brought investors a welcome vacation from the wearying declines in the stock market seen throughout much of this year. The large-cap Vanguard 500 Index Fund gained a solid 1.5%, and returns were even better for smaller-cap stocks. The iShares Russell Midcap and iShares Russell 2000 gained 1.8% and 3.6%, respectively, for the month. Broadly speaking, equity returns at the sector level reflected the increasing expectation that the world economy is slowing. This hurt energy and materials stocks—previously among the only bright spots for equities—while beaten-down financial and consumer-staples stocks rebounded. The dollar also rebounded strongly, and that hurt foreign equity performance in U.S. dollar terms. Vanguard Total International Stock Index Fund was down 5.1% for the month. Domestic bonds, as measured by Vanguard Total Bond Market Index Fund, gained 0.7% in August. The JPMorgan ELMI+, an index of short-term, local-currency, emerging-markets bonds, fell by 3.5% in U.S. dollar terms. Among other asset classes (in which we don’t currently have positions), REITs had solid gains, while high-yield bonds were up slightly for the month. Commodity futures had another tough month, dropping more than 7% in August, after falling almost 12% the prior month.

Our investment approach is long term, and we don’t concern ourselves with short-term performance since the factors that drive shorter-term performance are difficult to predict with confidence. That said, our more equity-oriented models have seen an extended run in which several managers have lagged their benchmarks. This has dragged down the overall relative performance of these models. We bring this up because we are disappointed that August didn’t show better relative results for our portfolios given the modest rebound in the overall market, and the shift away from energy and materials (where a lack of exposure had hurt these managers). But while several managers who have struggled of late had a decent month, several others who had been doing very well (in part because of exposure to energy and materials) did not do well in August. The surprising strength of small-cap also hurt, though longer -term we remain confident in our tactical overweighting to large-cap given our analysis of relative valuations and where we are in the economic cycle. Meanwhile our more conservative models were hurt in August by allocations to PIMCO Developing Local Markets (DLM), though here it is worth noting that some of that position was funded from our elimination of commodity futures this spring, which have been hammered in recent months (while DLM is down only slightly). So while that move doesn’t help our relative performance, since commodity futures aren’t in our benchmarks, it did prove timely and has contributed to our absolute performance. It also bears mentioning that since we originally added it to our balanced models, DLM has been a big positive and we continue to like it long term. We’ll address our model portfolio performance and our investment positioning in more detail in next month’s commentary.

On Our Radar Screen

It has been a very difficult market environment since the onset more than a year ago of the housing meltdown and ensuing credit crunch. The overall stock market is down sharply from its highs last October, but the degree of damage has varied widely across the financial markets. This has created a lot of pain, but it is also creating opportunities. These are coming in a number of forms. At the individual stock level many managers we talk to are reporting finding exceptional opportunities—in some cases as good as they’ve ever seen. At the asset class level, we are seeing some areas getting more attractive on a relative basis, and are keeping a close eye on these. One aspect of this environment is that unusually compelling opportunities are being created in the fixed-income arena. This is happening in part because some troubled financial institutions are forced to sell bonds at steep discounts to shore up their balance sheets. The unique nature of this market environment has our research team enthusiastically working long hours to get their hands around how this all might play out, in terms of both risks and longer-term opportunities. Next month is the end of the third quarter, and we will discuss then our investment views in detail, including opportunities and risks. For this month, we are going to summarize a few of the major items on our research team’s radar screen.

Fixed-Income Opportunities

Several well-known fixed-income shops are offering vehicles in a partnership structure to take advantage of opportunities in the credit markets. One in particular we are evaluating closely is offered by TCW. Jeff Gundlach, the head of their fixed-income group, was well ahead of the curve in predicting the housing meltdown and credit crisis, and while he remains very negative overall about the near-term prospects for a housing market recovery he is nevertheless reporting finding exceptional longer-term investment opportunities in the residential mortgage-backed securities area, where AAA rated Alt-A mortgage pools (not CDOs) are selling at severely depressed prices. We believe the risk at this point is quite low and return potential in a base-case scenario (that assumes a significant worsening in housing and default scenarios) could exceed 20%. There is also some opportunity in subprime securities, though TCW believes the Alt-A opportunity is superior.

This seemingly too-good-to-be-true opportunity exists because investors and the ratings agencies never believed that home prices would fall enough to endanger the AAA tranches of these securities. Investors who thought they were buying low-risk securities later realized that there was, in fact, credit risk as well as sizable market (price) risk. This realization has resulted in a massive imbalance between the number of sellers of residential mortgage-backed securities and the number of buyers. This imbalance exists because financial institutions need to strengthen their balance sheets, a process that includes clearing off securities that may continue to suffer from price risk and are likely to be downgraded by the rating agencies (many still carry AAA ratings though downgrades are extremely likely). Because there are not enough buyers to absorb the large volume for sale, prices have become extremely depressed.

Benefiting from these will require the patience and fortitude to handle possible near-term pain in the form of additional markdowns as the housing market continues to struggle, resulting in more mortgage-related losses. But “mortgage math” lends itself to scenario analysis, and amidst the pain and fear, Gundlach and other bond managers we respect report finding excellent opportunities in which they are highly confident in the payoff even in very bearish scenarios. While fixed income isn’t usually an area where we see exceptional risk/return opportunities, there is nothing usual about this market.

Mutual Funds that Invest in Alternatives

“Alternatives” has become something of a buzz word in the investment world, as the low returns from stocks and bonds have created a marketing opportunity for strategies that take unconventional approaches to earning returns that are not dependent on or correlated with the returns from stocks and bonds. We have looked at a number of alternatives funds to date (including Nakoma Absolute Return, which we wrote about last month) but are now in the beginning stages of a concerted effort to systematically review this space and determine what, if any, opportunities there may be.

The first goal will be to define what our alternative universe is. It is common for people to label any fund as alternative if it doesn’t fall into the traditional, long-only mutual fund strategy. Practically speaking, the alternative universe consists of various strategies reflecting different opportunity sets and investment objectives. These range from various hedge-fund-like strategies (such as long-short, market neutral, event-driven, and hedge fund replication) to currency strategies, and leveraged and inverse strategies. We will focus our efforts on the strategies most likely to fit within our overall approach, which we expect will include certain currency strategies or hedge-fund-like strategies.

While we are approaching our research with an open mind, there are also a number of reasons to approach it with caution. One is our belief that most skilled managers who run hedge fund strategies can make much more money with a true hedge fund structure (a private partnership or LLC) without all the hassle of a public fund (transparency, independent boards, etc.). So we think the skilled managers will be hard to find in the public fund world. We also believe that the wave of alternative funds launched in the last several years reflect marketing opportunities more than merit. Importantly, we do not believe investors need to own alternative funds for the sake of allocating some portion of a portfolio to a new, popular asset class (albeit one that can’t even be defined cleanly). Our research focuses on finding strategies that will either increase our model portfolios' returns or reduce their risk (or a combination of both). As with all of our fund research, before allocating any money to a fund we would have to identify highly skilled managers with a proven track record of delivering performance consistent with the strategy’s mandate. It is likely that many of these new funds simply do not have a sufficiently long track record for us to evaluate. For hedge fund strategies in which return is purely a function of manager alpha, we’d want to own more than one manager. That said, we have begun to screen the universe and dig in more deeply on some options that look interesting. If we find any that we believe are compelling (or possibly just interesting or promising) we will report on them.

Asset Classes

REITs—Over the past month or so, we’ve continued our research on REITs in order to improve our framework for determining when we would take a tactical position. Our most recent work involved conversations with public and private real estate investors, where our goal was to gain insights that would help us fine-tune our potential return ranges under various economic scenarios. For example, we want to understand what range of cash-flow growth is likely under different economic and interest rate scenarios, and how might that impact cap rates and ultimately property values. We also worked to establish a narrower range of trigger points based on our expected return from various levels.

We currently believe REITs are in a fair-value range and priced to generate returns in the mid to upper single-digit range, which is in line with equities, but more attractive than bonds over our five-year time horizon. This conclusion is based on several scenarios we’ve run with varying growth and interest rate assumptions. Importantly, all of our scenarios assume some increase in interest rates over five years which is a headwind for returns. Meanwhile, we are in the process of assessing whether REITs should be included as a strategic (default) asset class in our neutral model-portfolio allocations (see below for more on our revised neutrals), and if so, how we should fund the allocation. Though REITs have bond-like characteristics in the form of a significant dividend yield, their volatility and downside risk are in line with the broader equity market, and their correlations with equities are not stable, so we would likely take the money from equities. We are also in the process of evaluating whether any REIT allocation should be purely domestic or global. As part of our ongoing research efforts, we are revisiting our due diligence on some REIT fund managers, which may be used for the allocation.

High-Yield—In terms of risk, we think of high-yield bonds as comparable to a mix of stocks and bonds. Right now, on a relative basis high-yield looks fairly attractive in terms of potential returns versus a stock-bond mix on a pretax basis. But this is looking out over a number of years, and the near-term risks remain significant. Ideally, we’d want to invest at the point where the default cycle is close to a peak, given that historically the best absolute returns have been earned when that is the starting point. On the other hand, we aren’t going to just wait until we believe we are close to the peak in the default cycle and then invest. One reason is that there is no guarantee we can time the peak in defaults. Beyond that, we can look at valuations and return potential (based on a combination of spreads and estimated default rates and recovery rates) and determine the point at which we believe longer-term (three- to five-year) return opportunities are compelling relative to a stock-bond mix. That is something we can analyze with more confidence, and would be the basis for determining when we would pull the trigger. In the meantime, we continue to watch the asset class closely, as it is possible that an opportunity could be created quickly if investors turn sharply negative. We are also evaluating what vehicles we would use to take advantage of a tactical opportunity in high-yield.

Growth/Value—This is less pressing, but we are updating our work on relative valuations between the growth and value segments of the U.S. stock market. The objective for reviewing growth versus value is to: 1) update our knowledge on the new growth/value indexes (and existing indexes that are now calculated differently), 2) examine the investable securities in the growth/value space since a number of new ETFs have appeared giving options beyond iShares based on Russell indexes, and 3) review the arguments for having growth and value as separate dedicated allocations in our neutral allocations (see the final section below). We currently differentiate our neutral allocations between large and small but not between growth and value. Instead our default has been to be style-neutral between growth and value, except when tactical opportunities exist, but having dedicated exposure could make it more straightforward for us to reallocate to take advantage of any tactical opportunities that arise for either growth or value.

New Funds We’re Working On

There are a number of new funds we are actively researching. There may be differing priorities that underlie our decision to direct resources to a particular fund, but we aren’t going to get into what drives those decisions here. Also, it is important to point out that some (possibly many) of these funds will never wind up getting recommended or used in our portfolios. Whether a fund does or not is a function of other options within that asset class and whether we can gain sufficient confidence that it has an edge that will allow it to beat a benchmark over the long term. Also, there are plenty of funds out there with benchmark-beating records whose process isn’t one that we can get our hands around and gain sufficient confidence to recommend. This doesn’t mean they aren’t good funds, just that our process doesn’t give us the confidence in their edge we require to invest. All that said, our choosing to do work on a fund reflects our initial belief that it is worth looking into. Among the funds we are actively researching at this time include PIMCO’s new Unconstrained Bond fund, Osterweis, Fairholme, BlackRock Equity Dividend, Eaton Vance Large Cap Value, Evergreen Intrinsic Value (subadvised by Metropolitan West Capital Management), Tocqueville, and Touchstone Value Opportunities (subadvised by Clover Capital Management) to name a handful.

Progress Update on Our Revised Neutral Allocations

As noted more than a year ago, we have been actively revisiting our neutral (default) strategic allocations that are the starting point for our model portfolios. There are several reasons we decided to revisit our neutral allocations. One is that the environment has changed considerably since 1998, when we developed our current neutral allocations. Back then we sought to create basic portfolios consisting of only broad, well understood, and widely used asset classes comparable to what potential clients might use on their own. We set the allocations such that specific risk targets were met, based on 12-month loss thresholds (meaning that it was statistically unlikely, though not impossible, for each allocation to lose more than its target). We then default to these allocations, deviating only when we believe a compelling tactical opportunity exists, and then deviating in such as way as to capture additional potential return without increasing the chances of violating our loss thresholds. Taking advantage of tactical opportunities is one way we seek to add value. The other is to implement the core allocations with active managers in whom our due diligence gives us confidence that they will beat their benchmark over the long term. We don’t, however, want to use active managers for tactical asset-class positions, since we can’t be sure our holding period will be sufficiently long to enable an active manager to add value. So, where available, we use index vehicles there instead.

So with that as the backdrop, a number of things have changed in the past 10-plus years that led us to reconsider our neutrals. One is the significant increase in the availability of both data and investment vehicles for a broader range of asset classes. Some of these asset classes have the potential to add value longer term by being part of a default allocation. However, for those asset classes not in our current neutrals, our default is not to own them unless they are at compelling valuation levels, which means that we may miss out on any long-term portfolio benefit from their risk-reward characteristics.

We have considered a number of new asset classes in the course of revisiting our neutrals. We have computed optimum portfolios across different historical environments using different asset class mixes, and spent time considering what kinds of scenarios we think we might see in the decade ahead. We have considered secular trends such as the increasing growth of developing economies like China and India, the impact of global growth on the demand for resources and possible longer-term inflation trends, and reduced dependence on the U.S. as the primary global economic engine, to name several. These factors influence our thinking in considering how to construct default, long-term portfolios that will generate the best returns given our risk targets. Some of the asset classes we could wind up adding to our portfolios include REITs, commodity futures, and possibly dedicated emerging-markets equities. We will report in much greater detail on the changes to our neutral allocations when they are finalized, which we expect to happen in the fourth quarter.

In closing, there are always a range of research projects in process at any given time, but we can say that this is both one of the most challenging and promising environments we’ve come across. We are excited about the potential to add value through the research initiatives that are underway, and will report more in the months ahead.

—Stapp Financial Planning, PLLC

This information is also available at www.stappfinancial.com, or you can download a PDF version. To contact us about the newsletter, 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.