Monthly Investment Commentary

Most asset classes turned in fairly good numbers in January. Small-caps (up 9%), international stocks (up 6.9%), and REITs (up 7.3%) were the biggest gainers, but the S&P 500 had a solid month as well, gaining 2.7%. PIMCO Commodity RealReturn (commodity futures) and PIMCO Developing Local Markets (emerging market short-term bonds) both did well, gaining 1.6% and 3.2%, respectively, and outpaced the Lehman Aggregate Bond Index, which was flat. While our tactical asset allocation helped our model portfolios’ performance, most of our equity managers trailed their benchmarks in January, which resulted in our models underperforming. This is a very short period for making performance assessments, though, and is not a cause for concern.

Questions and Answers

We believe that intellectual honesty is a requirement to success in the investment business. Being intellectually honest means asking yourself difficult questions, being aware of your biases and trying to fairly and rationally answer them and make good decisions based on what you can and can’t know. We have the added benefit of a large family of subscribers, who also like to ask us difficult questions. If we haven’t thought carefully about these questions we don’t deserve your trust. We periodically share our investment thinking in the form of a Q&A, and plan to do this more regularly. We have always liked the format of the Q&A, since 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. This question-and-answer piece was worked on jointly by members of our research team, and addresses questions we received during the past several months.

What will likely happen to equity and bond markets if residential real estate prices suffer a sizable decline in most major metropolitan areas in the same year?

A large decline in home prices would likely have a significant negative impact on consumer spending and would probably cause a recession. Consumer spending would be hurt for four reasons. First, take-out financing (where homeowners borrow against their equity), along with refinancing at lower rates, have been important factors in supporting consumer spending in recent years, and an environment of falling housing prices would put an end to this. Second, a strong housing market has stimulated first-time home ownership as well as existing homeowners trading up to larger homes, fueling more housing-related spending. If the growth in home ownership slows, this spending would probably decline significantly. Third, a meaningful decline in most house prices would very likely depress consumer confidence. Home ownership is at an all-time high and easily represents the largest household asset. Thus, the wealth-effect from housing is likely to be much more significant than from the stock market. Finally, there has been significant job growth in housing-related industries (home building, mortgage brokers, banking, etc.) and a decline in the housing market will negatively impact employment, which in turn would hurt consumer confidence and spending.

The evidence of a housing bubble (including the use of aggressive mortgages, significantly declining affordability, low down payments, and the high volume of investment properties) suggests that certain important markets may be significantly overvalued and increasingly impacted by speculative activity, but the evidence at the national level is less clear. In our view, however, the bigger concern is that a mere flattening out of home prices or mild declines could impact consumer spending enough to be a meaningful drag on the economy, possibly enough to cause a recession. In our scenario analysis, we have evaluated the impact of both mild and severe recessions on our models, and in both cases we believe we are adequately diversified so that we would probably not violate our loss thresholds, and if we did, it would not be by much.

Are you concerned about variable-rate mortgage risk if interest rates rise?

The data we have seen suggests that the impact of rising rates on holders of variable-rate mortgages will be gradual and that this risk, in and of itself, is not material enough to meaningfully harm the overall economy. However, materially higher rates would impact the economy in a variety of other ways and collectively this would not be friendly to financial assets.

How close are you to tactically overweighting growth stocks and large-caps, or underweighting small-caps?

When evaluating growth versus value and large-cap versus small-cap, our decision-making centers on valuation analysis. For example, we’ll look at the current growth P/E compared to the current value P/E, and if it’s lower than it has been historically, that suggests better-than-average valuations. Of course, we weigh earnings-growth estimates, our position in the economic cycle, historical performance trends, and other factors, but valuations are the heart of it. Right now, some measures show growth stocks as somewhat inexpensive relative to value, and some value and GARP managers have been finding high-quality companies to buy that in years past were owned predominantly by growth managers. However, the valuation data and other evidence are not compelling enough to warrant a tactical overweighting at the portfolio level. Our “fat-pitch” discipline requires that we have a very high conviction before making a move, and we do not currently have that conviction. For us to deliberately overweight growth, one of two things (or a combination of both) would need to happen: Growth would need to continue to underperform value by a fairly significant amount, or company earnings in the growth sector would need to outpace those in the value sector without a commensurate upward adjustment in growth stock prices. Either one of these events would make growth more attractive than it is today relative to value. We cannot know if or when this will happen, but we can say that a change to our model portfolios is not imminent. In the meantime, the fact that some of our value managers own some stocks that are growthier than normal suggests that our portfolios de facto have slightly more growth exposure than what appears on their face.

The same logic applies to small-caps relative to large-caps. The main difference here is that the data more clearly reflects an unattractive valuation picture for small-caps. But assessing valuation is not an exact science, and for that reason we think in terms of ranges. At this time, small-caps remain within what we consider to be their fair-value range relative to large-caps (albeit at the upper end of this range), and this does not meet our strict criteria for making a change in our tactical positioning.

Did you get it wrong on REITs?

We owned REITs in the late 1990s, and while the stock market was climbing to bubble levels most investors were dismissive of our view that REITs had better three-to-five year return prospects than the S&P 500. After four years of great returns we sold our REIT positions in spring 2004. Since that time (despite a sharp decline shortly after we sold) REITs continued to perform strongly in both absolute and relative terms, prompting some to again question whether we made a mistake on REITs.

To judge whether we made a mistake one must first decide whether that judgment should be based on REITs’ performance after we sold, or whether it’s judged in the context of our investment process. Our investment process recognizes that it is not realistic to try to get every asset class right, especially over shorter time periods where performance is more likely to be affected by temporary factors that are impossible to predict. Instead, we do careful fundamental valuation analysis in an effort to identify when an asset class is very cheap, and we want to hold it until it gets back to fair value (or a little beyond). Over the long term we believe setting a very high bar for a tactical allocation raises our batting average and helps us avoid making mistakes that will hurt performance.

We do not think it makes sense to own an asset class when valuations are getting stretched, since overvaluation itself is a meaningful type of risk. In the case of REITs, valuations were no longer clearly cheap based on comparisons to underlying net asset value (they were at a 27% premium) and while we realized that net asset values could be re-rated upward we were not willing to bet on that outcome. Even after their decline in 2004, REITs still weren’t attractive relative to equities, and therefore did not meet our fat-pitch threshold.

Will REITs ever become a permanent allocation in our models and what factors will you look at in making this decision?

We have debated this question on occasion. When we set up our neutral allocations we had several criteria for evaluating asset classes for inclusion:

1. We require a lengthy data history to allow us to understand and evaluate risk, valuation, expected returns, and correlations. REITs do not have sufficient data history to pass this test. We have data from the mid-1970s but REITs were not much of an industry for most of that period; the aggregate market cap of all REITs was less than $10 billion around 1990 and there was little sector diversification. The industry evolved dramatically in the early 1990s, and while we believe the data is sufficiently reliable now, the data history is still too short for our purposes.
2. We wanted mainstream asset classes that clients coming to our firm were already likely to own. Our thinking was that our neutral portfolios should reflect a prudent asset allocation based on asset classes that typical clients would probably choose to purchase without professional financial advice. That way our performance relative to that benchmark would be indicative of our theoretical value added. At that time REITs were not a mainstream asset class and though they have become more popular we still don’t view them as a widely owned asset class among the kinds of individual investors we serve.

It is possible that we will revisit our criteria and re-think REITs at some point in the future, but right now they do not meet either of these tests. For the foreseeable future, we will own REITs only when valuations are sufficiently compelling to warrant a tactical allocation.

Do you still feel as strongly that a sub-5% Treasury yield is unsustainable? How many years does it have to remain below 5% before you question this assumption?

The key issue here is that our interest-rate assumption has a big impact on our stock valuation model. The lower the yield assumption, the more attractive stock valuations appear to be. The flaw with this approach is that a sub-5% Treasury over the long run suggests an economic environment that would not be robust. In that type of environment, earnings growth would be slower and deflation risk would be an ongoing threat. It is likely that a higher risk premium would result so that a lower P/E would be applied to what would likely be a lower level of earnings.

The only place where our 5% floor makes a big difference is on equity valuations where it helps us avoid an unrealistically attractive reading on equities. With regard to the outlook for bonds, the impact of using a somewhat lower (or higher) interest-rate assumption on the expected returns for bonds over a multi-year period is actually very small.

You have significant bets away from the neutral allocation within the investment-grade bond portion of your balanced models. Doesn’t this expose the portfolios to more risk in a recession scenario?

The short answer is yes. At present we have somewhat more risk exposure to a recession than we would have if we held a neutral allocation to intermediate-term investment-grade bonds. However, we have analyzed a range of scenarios and based on that analysis we believe we are gaining return potential in a majority of environments without giving up too much of our recession hedge. If we were confident a recession was imminent and the market hadn’t yet priced it in, we would own more investment-grade bonds. However, we don’t know the timing of the next recession.

It is possible that at some point we will extend duration or increase investment-grade exposure if we become more concerned about recession risk or if interest rates rise to a level where the yields are more compelling.

How does an inverted yield curve impact your views on the economy, asset classes, and portfolio strategy?

When short-term interest rates move higher than longer-term rates, a recession often follows, but there have been exceptions and this is likely to be another one of those exceptions. Dan Fuss, manager of Loomis Sayles Bond, and others we respect believe that the overall level of interest rates is too low to constrain economic activity to recession levels. Fuss also believes that the inversion is impacted by the imbalance between long-dated bonds and the demand for them. These views make sense to us.

If a recession does end up happening, and earnings decline accordingly, stocks will probably suffer a temporary correction. However, because stocks are not overvalued in our view—and may actually be undervalued—we think a cyclical bear market would probably be mild. We can’t know if a recession will happen in the foreseeable future, but we do have some defensive hedges in place in case of a market downturn triggered by any number of factors. While the inversion is not a major worry, as always we will be watchful for signs that the big-picture risks that lurk in the background are becoming more threatening.

Interest rates also impact valuations, but because most of the interest-rate-dependent valuation models we are aware of use the 10-year Treasury yield, they are not impacted by the shape of the yield curve per se. And as we mentioned above, we stipulate a minimum value of 5% for our 10-year Treasury assumption.

Are there any new asset classes you are researching?

Over the last year or so we have researched commodities futures and local currency emerging-markets debt, both of which we use in our balanced models. Going back a couple years, we’ve also looked at hedge funds as an asset class and we’ve researched several hedge-fund-like mutual funds, as well as foreign bonds and TIPS. At present we are not actively researching any other new asset classes, but we are always looking out for new developments.

Are muni bonds preferable to taxable bonds across all durations?

As of late January, municipals are preferable across all durations for most investors. The degree of attractiveness is greatest at the longer end of the yield curve, where munis yield almost as much as Treasuries. Among intermediate-term bonds, munis are still attractive relative to a mix of corporate and government bonds, but it’s a close call for investors in the 28% and lower marginal tax brackets, in part because we believe funds like PIMCO Total Return, Loomis Sayles Bond Fund, and FPA New Income have the flexibility to add more value through active management than do their tax-exempt peers.

How are things going at TCW without Bickerstaff?

We continue to have regular contact with Craig Blum and Steve Burlingame as well as members of the TCW research team. Moreover, Glen Bickerstaff continues to be engaged in stock discussions. In short, we continue to be very impressed with Blum and Burlingame with respect to their intellect, discipline, and the knowledge of the companies, and Bickerstaff’s involvement gives us additional comfort. Our assessment is unchanged and we remain very confident in the fund’s continued potential to outperform its benchmarks in the future.

Do you use separate accounts or hedge funds for your clients? Why or why not?

We do not use separate accounts because we believe the universe of active mutual fund managers offers better choices. Several years ago we looked at many of the active managers available in wrap programs and were generally underwhelmed. In the separate-account world there are potential benefits from a tax-management standpoint but we found that in many cases the reality was that the separate accounts were not being run with a high level of tax awareness. Using funds also generally allows for more manager diversification and greater ease of “hiring and firing” managers. Though there are exceptions, we concluded that despite the popularity of separate accounts the reality was that our clients would generally be better served with mutual funds. We believe that separate accounts are in many cases being misrepresented in their marketing. (Note: we have not looked at the universe of separate-account managers for a few years now so it is possible that there are more good options available today than there were back then.)

With regard to hedge funds, a couple of years ago we did extensive analysis of the hedge-fund world and ultimately concluded that they were not a compelling investment option. The problem starts with the need for diversification across multiple hedge funds which, given high minimums, means that most clients would have to use a fund-of-funds. The problem with almost all funds-of-funds is that the aggregate fees are excessive (hedge funds have base management fees, performance fees, and administrative fees, and in the case of funds-of-funds there are two levels of fees). On top of the fees, most hedge funds are extremely tax inefficient because a significant amount of the return comes in the form of short-term capital gains or ordinary income. Third, with all the money chasing hedge funds we fear that some of the strategies will become less effective resulting in lower returns. That said, well run funds-of-funds with low fees (of which there are not many) may make sense for some tax-exempt accounts. We have incorporated them in a few very large institutional accounts where it was a mandate. However, we may be reducing or eliminating our exposure because of fee increases being pushed through by many of the successful underlying hedge funds. In the future, a better alternative may be hedge-fund-like mutual funds. We researched most of the available funds a couple of years ago and were generally unimpressed. However, since that time more funds have been launched and it is possible that there may be some worthwhile options that are more reasonably priced. At some point there may be enough alternatives to put together a diversified position that could be incorporated into a broader portfolio.

What about all the long-term macro risks? When do they stop being long term and start being near term? When you realize this will it be too late?

This is a judgment call that we have to make, and it’s difficult because the information is always incomplete. However, we are well aware of the difficulty in identifying when a long-term risk becomes a short-term risk and this is why we do scenario analyses that assess the damage to our model portfolios if risks we identify come to pass in the short run. Thus, for example, we look at a dollar-crash scenario even though we don’t think it is likely in the short run. This allows us to assess the potential damage and determine whether we should consider building in diversification that would help mitigate the downside risk to the portfolio.

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