Monthly Investment Commentary

Most domestic equity asset classes showed small losses in August, with the S&P 500 declining 0.9%. Small-caps did slightly worse, and the performance of growth versus value varied among the different market-cap segments. REITs had a particularly tough month, losing 3.8%. The Lehman Aggregate Bond Index gained 1.3%, and foreign bonds did slightly better. Among the better-performing asset classes were foreign stocks, with the MSCI EAFE index gaining more than 2.5%, and the Dow Jones Commodity Index, up better than 7%. Our model portfolios had a decent month, as the tactical allocations in our three balanced models helped them beat their benchmarks, while our equity model lagged.

Are Growth Stocks a Fat Pitch?

According to Bill Nygren, who runs the value-oriented Oakmark and Oakmark Select funds, “Today most stocks are priced at P/E multiples close to the S&P 500 … In fact, the range of P/Es has narrowed so much that we believe the better values today are generally the superior businesses where the market isn’t demanding significant P/E premiums. The opportunity in 2000 was to identify the best prices; today, we think more of the opportunities are in identifying the best businesses.” Nygren is not the first person we’ve heard make this kind of observation, and his comments are at least partly reflective of what’s been going on in the market over the past five and a half years.

Value stocks have been on a tear for a long time. In four out of the past five calendar years, the Russell 1000 Value index has massively outperformed the Russell 1000 Growth, after beginning that period hugely undervalued (value actually outperformed in all five years, but it did so only slightly in 2003) and two-thirds of the way through 2005 the story remains the same. Since the bursting of the tech bubble in March 2000, the Russell 1000 Value has outperformed its growth counterpart by nearly 16 percentage points annualized (as of 7/31/05). This more than offsets the superior gains achieved by the growth index during the run-up in 1998, 1999, and early 2000. So a logical question for investors to be asking themselves is: Given the massive and sustained underperformance of growth stocks, and the fact that several value-oriented managers are finding good stocks in traditional growth areas, has this asset class become a fat-pitch investment opportunity?

The short answer is that while some data show growth to be marginally more attractive than value (while there are no signs that value is more attractive), we don’t think growth is a fat pitch. From a macro-data standpoint, the data is equivocal; different metrics or data sources suggest different conclusions. For example, Leuthold’s Royal Blue indexes show growth stocks as being very attractive on a relative basis (see Chart 1). Leuthold describes this series as follows: “The ‘Royal Blue’ work compares relative and absolute valuations of the 99 favorite large-cap institutional stocks. We divide these large-cap stocks into three P/E multiple tiers comprised of 33 stocks each. The High P/E Tier is viewed as a proxy for ‘Large Cap Growth’; while the Low P/E Tier represents ‘Large Cap Value.’” If one were to look at this chart and make a conclusion based solely on where the line falls, it would have to be that growth stocks look attractive. But this data series has several limitations: Because the Royal Blue tiers only have 33 names in them, they may not represent an accurate sample of the entire asset class. With so few names, any aggregate data could easily be distorted by a small number of stocks. Furthermore, if one style is particularly in vogue among institutional investors, the starting list of 99 names may be suffering from a bias before it even gets separated out into valuation tiers. We think this is one of several sources worth considering, since these are widely owned names and theoretically are influential in the benchmarks, but it’s far from robust enough that we ’d want to hang our hat on it.

The Bank Credit Analyst (BCA)—one of our favorite sources of unbiased macro-level analysis—also came out with an article this month suggesting that investors should overweight growth stocks. Many of the points they make provide additional insights on the subject (particularly in how the fundamentals in specific sectors can have an impact on the style indexes), but unfortunately much of their argument rests on factors such as relative performance and historical trends in market leadership, which while interesting and useful to consider, are not sufficiently robust that we’d assign them a huge amount of weight. BCA also briefly discussed valuations, but they relied on only one data series, S&P/BARRA. Using those numbers, growth looks attractive (although not fat-pitch attractive), but unfortunately these indexes also suffer from some structural flaws and therefore aren’t definitive, which lowers our conviction in the conclusions they suggest.

To get a more complete look we evaluate other data as well, including P/Es based on forward rather than trailing earnings, price/sales, measures from different data providers who construct their universes differently (Russell, BARRA, Leuthold, etc.), and so on. The idea is to gain a composite picture that tells us as clearly as possible what’s really going on in a particular asset class. One of the data series we like best comes from Russell, which we usually use for benchmarking purposes when we are analyzing mutual funds. Using Russell’s P/E ratio data, growth does not look undervalued relative to value, and appears to be very comfortably within a fair-value range. Since this chart includes valuations based on forward earnings, it also takes into account any differential in expected earnings growth that might factor into the analysis.

So while there are some signs that growth is marginally more attractive than value, there is enough uncertainty that our fat-pitch standards aren’t met. The bottom line is that for us to make a deliberate, tactical move away from our neutral weightings, we need to have a high conviction level that we’re going to be rewarded for doing so. In our conventional fat-pitch approach, that means we should be highly confident that we will see materially better returns over a three to five year time horizon. From the defensive fat-pitch standpoint, we’d need to feel that we are hedging a specific risk (without raising our exposure to other, similarly probable risks) and that there is a solid chance we’ll make at least a little extra return to boot. Growth stocks fail to meet either of these standards. From a return standpoint, there’s no reason to expect big numbers out of growth stocks (valuations aren’t hugely compelling), and we don’t see any obvious hedging benefit from owning these kinds of stocks. Having said that, there may be opportunities at the individual stock level.

Setting aside the macro analysis, if a stockpicker we respect as much as Bill Nygren owns Texas Instruments, Wal-Mart, and other growth stocks, isn’t that compelling evidence that at an individual stock level, growth stocks are the better opportunity? That may or may not be the case, but in any event we favor flexible stockpickers who are in a position to take advantage of the most compelling opportunities they can find at the stock level, regardless of whether they screen as value or growth. Our due diligence process—both up front and ongoing—gives us confidence in our managers and helps us differentiate those who are flexible (which we like) from those who lack a consistent investment discipline (which we don’t like). We think flexible managers like Bill Nygren from Oakmark, Chris Davis and Ken Feinberg from Selected American Shares, and others give us exposure to the stocks that those managers think have the best investment prospects, rather than those that fit neatly into a specific style box. So, de facto, we might already be overweight to growth because of what our fund managers are doing. Ultimately, we are less concerned with being precise on the growth/value mix than we are with making sure we have fund managers who can take advantage of the most compelling investment opportunities they can find.

Research in Progress

As we’ve mentioned in prior commentaries, we’ve recently been re-evaluating two of our tactical positions. The first is our underweighting to investment-grade bonds via positions in cash, and the second is our choice of investment vehicle for hedging against a sudden decline in the U.S. dollar. We are in the process of finishing our work in both of these areas, but wanted to share some of our thinking thus far.

The current yield on the Lehman Aggregate Bond Index—as of this writing—is roughly 4.7%, compared to a yield of about 3.1% on a money market fund. Over a longer time period, this yield advantage is not inconsequential, and our most recent scenario analysis suggests that in most environments, investment-grade bonds beat or equal cash given a five-year horizon. True, our base-case scenario assumes a modest rise in interest rates (conceivably induced by a decline in the dollar, but several other factors could lead to the same result), but even in this scenario, we no longer believe that cash has a clear advantage over bonds. If we shorten the horizon to one year—which is more germane to our loss thresholds—the arguments for cash get a bit better in some scenarios, but it’s difficult to make the argument that they meet our defensive fat-pitch standard.

This ties back to a larger issue, which is the overall positioning of our fixed-income investments. The aggregate effect of how we’re positioned—cash, the use of eclectic funds like Loomis Sayles Bond and FPA New Income, as well as our commodity futures holdings—means that we are hedging against a rise in interest rates at the cost of increasing our risk in an economic slowdown (especially if the economy tips into outright deflation). Put another way, if deflation comes to pass, the aforementioned investments are not likely to do as well as conventional investment-grade bonds, and as such would provide less ballast against portfolio-level losses in equities. Given some of the U.S.’s structural imbalances, rising rates are a possible precursor to deflation (in which case cash could temporarily outperform bonds), but deflation—or at least disinflation—could appear in many different ways, and we’re not comfortable making a big bet on rising rates if it means raising our risk in a deflation scenario. Previously, we felt that it was more important to protect against a rise in interest rates, but as the economic cycle has progressed and our assessment of macro-level imbalances has evolved, so too has our thinking on how our fixed-income allocations should be positioned.

So what’s preventing us from making a change right now? The main reason is that we are still evaluating our foreign bond positions, and given that we don’t feel a pressing investment need to act quickly on our cash positions, we’d rather finish our analysis and then make all the portfolio moves at once to keep things straightforward. By and large, we don’t see our current positions as posing a significant risk to the portfolios, so we do not see the need to make the move right away. However, short-term risks are notoriously hard to assess. Maybe the damage from Hurricane Katrina causes a sudden economic slowdown that sets off a deflation spiral? This goes into the unknowable category, and is short-term in nature. And even if it did result in an economic slowdown, the rise in oil prices would at least temporarily boost our commodity futures positions, providing an offset against potential equity losses. Certainly there are other risks we can’t foresee, and so we don’t want to put off these changes indefinitely, but since we expect to have our work on a foreign bond fund alternative finished in the next month or so, we think most investors are probably going to be better off waiting and making both moves at the same time.

And this brings us to the other issue: the risk of a dollar crash and how we’re hedging it. We continue to believe that the U.S. current-account deficit is unsustainably high, and something will need to happen to restore equilibrium. The most likely change is a meaningful decline in the U.S. dollar. Our analysis thus far has been that owning investment-grade bonds that are denominated in non-dollar currencies is the most effective way to hedge this risk: if the dollar drops, these investments would show very nice returns, thus offsetting what would likely be pretty big losses in most U.S. assets, namely stocks and bonds. In theory, the foreign currencies we’d most want to have exposure to would be our biggest trading partners, and more specifically those we run big trade deficits with: China, Japan, Mexico, and Canada, among others. In the past, we had limited choices in achieving this exposure, particularly from fund companies in which we had a high degree of confidence. However, PIMCO recently launched the Developing Local Markets Fund which currently owns very low-duration investments that are broadly diversified across many countries and regions, all of which are considered emerging markets. Since China and Mexico are huge trading partners against which the dollar has not already declined very much, having exposure to those and other emerging countries has a lot of appeal. However, there are also many risks, several of which we’re still trying to get our hands around. The key question is whether this fund would provide more targeted exposure and improve the quality of our hedge relative to PIMCO Global Bond or Loomis Sayles Global Bond, and that is the substance of what we ’re working on right now.

We expect to have these issues resolved shortly—it’s our highest research priority at the asset-class level—although we cannot provide precise guidance right now as to what the final outcome will look like. Regardless, we will report back as soon as we have more details to share.

— Stapp Financial Planning, PLLC

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