Monthly Investment Commentary

Larger-cap stocks, as measured by the S&P 500, gained a modest 0.6% for the month of July, while the smaller-cap Russell 2000 lost 3.3%. While the dominance of smaller-caps that we’ve seen in recent years reversed in July, the dominance of value remained notable. The Russell 1000 Value, 2000 Value, and Mid Cap Value indexes all outpaced their growth counterparts by at least 300 basis points in the month of July. Domestic investment-grade bonds and emerging-market short-term bonds were up 1.4% and 2.6%, respectively, and commodity futures fared even better, gaining more than 3% during July. Our models trailed their benchmarks in July as most of our equity managers lagged their respective indexes.

Questions and Answers

We often share our investment thinking in the form of a Q&A, which is a format we like because it lets us address important questions individually without worrying about being limited by a particular theme or subject. We can cover more ground, and readers can find the areas of concern or interest to them more easily.

If the Fed raises rates to 6% this year and short-term money market rates rise accordingly, what is the argument for holding bonds as opposed to cash?

While we do not believe we can confidently assess what interest rates are going to do in the short run, we have spent a significant amount of time thinking about the longer-term outlook. Some of the reasons we don’t believe that a significant and sustained rise in inflation is terribly likely (e.g., globalization, productivity, a housing slowdown, and the Fed has already raised rates significantly). If long-term inflation is relatively unlikely, then the odds that the Fed will have to significantly raise interest rates are diminished.

A bigger concern is that the Fed winds up worrying too much about fighting inflation and actually triggers a recession by raising rates more than is necessary. Should that happen, bonds would outperform cash. So while there is a short-term risk that bonds might not do well relative to cash, we believe the odds are that over the next several years, they will do as well as or better than cash. There are others who share this view. At least two of the bond managers we highly respect believe that we’re at or nearing the end of the interest-rate cycle, and big rate increases going forward are unlikely. In fact, those bond managers have been lengthening the duration of their portfolios in anticipation of a downward movement in rates.

Outside of these cyclical considerations, there are portfolio-level reasons why we favor bonds over cash. We own bonds for more than just their yield; they are an important diversifier in the event of recession or any other event that could cause equities to decline precipitously. Additionally, in a recession scenario, bonds will do better than cash. Even though we don’t think this is likely in the immediate future, it’s a risk we believe is prudent to protect against, and bonds provide that protection more effectively than cash.

Do you consider the new commodity futures exchange-traded notes to be a suitable alternative to the PIMCO CommodityRealReturn fund, especially in light of the PIMCO fund’s underperformance relative to the benchmark over the last year?

Recently Barclays introduced a new investment product they call the iPath ETN. ETN stands for exchange traded note. ETNs are unsecured debt securities issued by Barclays Bank PLC that are linked to the total return of a market index. Investors receive a cash payment at the scheduled maturity or early redemption, based on the performance of the index less investor fees. There are currently two iPath ETNs: one tracks the Dow Jones AIG Commodities Total Return Index and the other tracks the Goldman Sachs Commodity Index. Both ETNs have an expense ratio of 0.75%, which is comparable to the fees on PIMCO CommodityRealReturn Institutional fund (PCRIX). Unlike a mutual fund, however, investors will pay a brokerage commission to buy and sell ETNs.

The most intriguing aspect of the ETN is its apparent tax treatment. It appears that any positive returns from owning the ETN will be treated as long-term capital gains, as long as the ETN is held for at least six months. In contrast, gains in commodity futures index mutual funds (such as PCRIX and Credit Suisse Commodity Return Strategy) are treated as income or short-term capital gains. Given the differential between income tax rates and long-term capital gain rates, the tax benefits from the ETN structure could be significant. However, we note that there is some uncertainty with regard to the tax treatment of these investment vehicles because the IRS has not made a formal ruling as to how the gains will be treated. According to Barclays, ETNs should be treated as a long-term capital gain vehicle. But they also state: “The U.S. federal income tax consequences of an investment in the iPath ETNs are uncertain. It is therefore possible that the Internal Revenue Service may assert an alternative treatment.” We plan to research the tax treatment of ETNs further and will consider them for taxable investors.

With regard to PCRIX, it has underperformed the Dow Jones AIG Commodity index by about 700 basis points over the last 12 months. The key to understanding this underperformance is to look at the performance of TIPS (Treasury Inflation Protected Securities) versus the performance of Treasury Bills during this period. PIMCO invests the fund’s collateral in an actively managed TIPS portfolio in order to try to add value over the benchmark over the long term. The DJ-AIGC index is calculated based on the assumption that the collateral is invested in Treasury bills. Over the past 12 months short-term interest rates have moved up, yielding low to mid single-digit returns on T-bills. Meanwhile, real interest rates have risen, and so the return on TIPS has been negative. John Brynjolfsson, the manager of the fund, states that the underperformance is not due to the change in the fund’s portfolio from swaps to structured notes, the cost of which was only a few basis points. We remain comfortable owning PCRIX and are confident in PIMCO’s ability to add value over the longer term with the TIPS portfolio despite the short-term performance lag. (The fund is ahead of the benchmark since the fund’s inception.) But the recent period does highlight the fact that the fund will not always closely track its benchmark.

When you add a new asset class, how do you determine where to take the funds from? Have you considered adding REITs, hedge funds, or commodities?

The two main issues when we are considering an asset class change are 1) valuations and return potential for the new asset class relative to the other asset classes in the portfolio, and 2) the results of our scenario analysis, where we evaluate how an increase or decrease in various asset classes would play out in a variety of different environments.

Our goal with this process is to maximize our potential return in a steady-state scenario without increasing the probability or magnitude of a violation of our loss thresholds in a negative scenario. It is not uncommon that adding or overweighting a risky asset class—like equities—will cause a portfolio to perform worse in a negative scenario than it would have done had the move not been made. So we have to weigh the probability of a negative scenario coming to pass against the benefits we would receive in other scenarios. The case of a defensive fat pitch is a little different. In that situation, we are addressing a specific risk that is unlikely to occur but that would be significantly negative if it did. A defensive fat-pitch allocation hedges against this risk in a way that we believe doesn’t compromise our return potential in the higher-probability scenarios.

REITs and commodity futures are asset classes we follow on a regular basis. REIT valuations are pretty stretched right now, and we do not think they qualify as a fat pitch. Commodities are different from commodity futures (which we own), and we don’t follow them in a dedicated way. They offer less diversification benefit versus commodity futures, and they don’t have the same structural sources of return as commodity futures. In regard to hedge funds, we did a comprehensive study of the industry several years ago and concluded that in general, hedge funds were unattractive because of their fees, highly taxed returns, and high minimums. In addition we had concerns that the flood of money flowing into hedge funds would crowd some hedge-fund strategies, making it more difficult to generate attractive returns.

Why is the maximum exposure to foreign stocks only 20% in your neutral allocations when they comprise 50% of world market capitalization?

When we put together our neutral allocations we made a philosophical decision that the asset mix should represent a prudent mix that an average client could be reasonably expected to own. At that time the average U.S. investor’s allocation to foreign stocks was very low. So, when we were running optimizations to determine the ideal asset mix, we constrained the foreign exposure to 20% of assets because we believed that a higher strategic allocation to foreign stocks would begin to push too far beyond the domestic bias typical of most U.S. investors. At the same time, we knew we could move aggressively beyond that 20% limit whenever we believed we were presented with a fat-pitch opportunity. With that information, we then ran several optimizations to see what mix of domestic large caps, small caps, and foreign stocks—along with intermediate-term bonds—generated the greatest historical returns, given a targeted level of risk (as defined by our loss thresholds).

What is your opinion on the current conflict in the Middle East? How might it impact the markets?

From an investment standpoint, we are not hugely concerned with the events in the Middle East. However, this question is a good question for discussing how we typically evaluate geopolitical events. Any geopolitical event only has a material impact on investors if it impacts the economy. That’s why tragedies like Darfur don’t register in the investment markets. As a region that exports a huge amount of oil to the world, turmoil in the Middle East is certainly worth paying attention to and may very well have economic relevance. It’s tempting to let our fears of a worst-case scenario drive our investment decisions, so in analyzing the portfolio-level impact, there are always two questions we believe are critical to address:

• What is the economic impact? With the U.S. economy already showing signs of slowing, a further increase in oil prices would not be good news. Higher oil prices create a slightly higher risk of recession. Of course, higher prices may also cause the Fed to pause or end its string of interest-rate increases. As of now, we continue to believe that a recession is not imminent and we are not inclined to get more defensive, especially given the attractive level of stock valuations. However, the impact of events in the Middle East on oil prices is worth keeping an eye on. If the conflict spreads to oil-producing countries, it could pose a larger risk to certain economies around the world.
• What about the market impact? If things continue to heat up it wouldn’t be surprising to see investors overreact and drive a sharp market sell-off. If that happens, we would probably view that as a buying opportunity. Because stocks are already much closer to being cheap than being expensive, a material decline in stock prices would probably suggest that the market is already discounting a recession, even before a recession is a forgone conclusion. This is important. When that level of pessimism is priced into stocks, it often results in healthy returns from that point through the next market cycle. For what it is worth, Middle East violence has more often than not turned out to be a buying opportunity for investors rather than a signal of a big and lasting bear market.

We can’t say with complete certainty that the current problems in the Middle East will not result in further stock market declines but—the human tragedy notwithstanding—at this point this is not the type of major global economic event that is destined to damage the global economy. Of most importance, our view that equity valuations are already pricing in a significant amount of risk suggests to us that a sharp and lengthy stock market decline is unlikely.

— Stapp Financial Planning, PLLC

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