Monthly Investment Commentary

April was another good month for stocks, but there were some differences from prior periods. While the S&P 500 gained 1.3%, small-caps and REITs—which had previously been among the best-performing asset classes—were flat and down 3.7% respectively. Emerging-market short-term bonds (local currency) did well, gaining 2.7%, and foreign stocks were a bright spot, gaining more than 5%. Rising oil prices provided a solid tailwind for commodity futures, which climbed almost 7%, but rising interest rates contributed to a 0.2% loss for the Lehman Aggregate Bond Index.

Investment Q&A

Being intellectually honest means asking yourself difficult questions, trying to fairly and rationally answer them while being aware of your biases, and then making good decisions based on what you can and can’t know. We have the added benefit of a large family of clients, who also like to ask us difficult questions. If we haven’t thought carefully about these questions we don’t deserve your trust. We regularly 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.

Interest rates are rising; isn’t this bad for stocks?

Rising rates are often bad for stocks. For example, in 1994 the Fed unexpectedly started a round of interest-rate increases that lasted about one year. Over a two-month period that began in early February and ended in early April, stock prices dropped 9%. During that time the 10-year Treasury moved from 5.76% to 7.15% (later in the year the yield broke through 8%). However, it would be a mistake to assume that rising rates always telegraph a stock sell-off. Consider the last year. In early June of 2005 the 10-year Treasury bottomed at 3.89%. Recently it broke through 5%. Over the same period the S&P 500 is up around 9%.

Why do rising rates drag stock prices down sometimes and not others? Not surprisingly, the facts and circumstances can differ and these differences matter. Some of the key variables to analyze include the following:

• What were investors expecting? In 1994 the rate increase was unexpected. However, over the last year the Fed was clear about their intentions so investors were not surprised.
• What rate level is the increase starting from and how high might they go? In 1994 the rate level when tightening started was much higher than it was in the more recent round of tightening and the increase was significant. However, if rates are very low, as they were last year, there is room for them to increase without cutting the legs out from under the stock market. When rates were below 5%, the potential returns for fixed-income investments were still not overly tempting relative to equities. In addition, rates were not high enough to be very detrimental to consumer spending.
• What is the perceived risk to the economy and earnings? Because rates often rise in reaction to a strong economy, they can coincide with strong earnings growth, which is at least a partially offsetting positive. And though interest-rate increases are designed to slow the economy by virtue of higher borrowing costs that impact businesses and consumers, the impact on earnings can vary. Over the last year earnings have continued to grow at a very healthy pace and are expected to continue to do so this year, though the growth rate is expected to decelerate somewhat.
• Corporate balance sheets can also be a factor because rising rates mean rising borrowing costs. Presently, corporations are flush with cash so the need to take on debt is not great.
• Valuation levels when rates begin rising are also important. Based on our valuation model, stocks were right around fair value in 1994 when rates started rising, as compared to much of this past year when stocks have been closer to undervalued.

Looking forward, we don’t think it’s likely that rates will move sharply higher from here. However, earnings are decelerating and interest rates are no longer at a depressed level. So if we are wrong and interest rates do move much higher from current levels, there is increased risk of a stock market sell-off, though the impact could be muted by somewhat attractive overall valuation levels. If rates moved up another 100 basis points (as they have in less than a year) it is very possible stocks would suffer a correction.

Commodity futures (and PIMCO’s fund) have been very volatile over the past several months. Is this an attractive area to invest in right now?

Before we answer this question from a tactical perspective, we think it’s worth reiterating how we approach this asset class. Commodity futures are a unique asset class that can provide valuable diversification benefits in a traditional balanced (stock/bond) portfolio. Historically, on average, commodity futures have performed very well during periods when both stocks and bonds have done poorly. In addition to the diversification benefits, commodity futures have several identifiable and repeatable elements of total return that are not wholly dependent on the whims of the market; it is not a speculative bet on the direction of commodity prices. The elements of return to owning commodity futures include: 1) the “risk premium” earned for absorbing shorter-term price volatility, 2) the added return over time from rebalancing the components of the commodity futures index each year, and 3) the return on the collateral backing the futures investment. Over the very long-term, commodity futures have generated returns that are in line with equity returns and significantly higher than bond returns.

Our decision-making process on whether to own commodity futures at any particular point in time is a function of four main variables:

• Return expectations relative to other asset classes
• Where we are in the interest-rate cycle
• Backwardation—when futures prices are below spot prices. Investing in backwardated commodity futures generates a “roll yield” from replacing the currently expiring futures contracts with lower-priced, later-maturing futures. Some evidence indicates that the commodities with the largest backwardation have generated the highest historical returns, so this logic might also be applied to our overall assessment of the asset class.
• TIPS valuations (TIPS are the underlying collateral in PIMCO’s fund)

In theory, as commodity futures decline, their long-term return prospects increase. Commodity futures have moved up and down a lot in recent months, but over the last year the fund is up almost 14%, and over the last three years it has gained 21% annualized. So trailing returns have been strong, and combined with the fact that the stock market is in fair value territory (and possibly even undervalued), we don’t think recent returns do much to improve the outlook for commodity futures relative to equities. On the other hand, commodity futures are probably more competitive with bonds, and for that reason we are taking our small commodity futures positions from our bond exposure.

Moving on to other criteria, the futures backwardation data is not attractive right now. In fact, the DJ-AIG index is in “contango”—a condition where futures prices are actually higher than spot prices—and this is not bullish for commodity futures. However, the degree of contango is not way out of line with historical ranges, so this isn’t a clearly bearish data point either. With regard to Federal Reserve interest-rate policy, it seems likely that the Fed is nearing the end of its tightening cycle; the tightening has effectively been a nice tailwind of commodity futures. However, the end of the tightening policy does not necessarily mean that the Fed is about to start loosening, and loosening is really the signal that history suggests is an important exit signal for commodity futures. TIPS valuations are a tough call, but they are probably in a fair-value range, so this is neither a positive nor a negative factor.

In summary, our view on this asset class is not hugely enthusiastic right now—based on these criteria—and that’s part of the reason we are only using a 3% position in many client portfolios.

Many of the managers you utilize don’t like cyclicals (e.g., energy and industrials). Have you thought about what this means with respect to the overall diversification levels in your portfolios?

This is an area that we’ve been thinking about recently and are planning to spend more time evaluating. In the past, our view was that if several great managers all felt the same way about a particular sector or type of company—or had an inherent predisposition against it—then we were comfortable deferring to their judgment. We do not believe it makes sense to micromanage our managers, and if their collective thinking resulted in a meaningful amount of benchmark risk, this was okay with us.

However, as we’ve watched this approach in the real world, we’ve made at least a couple of important observations. First, while we often use two funds in each category (e.g., large-cap value) if those managers think the same way—have similar exposures and/or biases—are we really getting the full diversification benefit of owning multiple managers? Secondly, and perhaps more importantly, does using managers who have predispositions against certain types of companies or sectors limit their opportunity set (the answer being an obvious “yes”), and does the reasoning behind those self-imposed limits make sense? We are still in the early stages of thinking about this and don’t have the answers to these questions. Nor do we have any expectations as to what the eventual outcome may be, but this is something we’re planning to take a closer look at.

When a fund slumps, what is your process for monitoring the fund and determining if your confidence level should change?

Every time we analyze a manager on our Recommended list, our objective is to revisit the reasons we liked the fund in the first place, and look for evidence that either supports or refutes our original investment thesis. The intensity of this process is usually kicked up a notch when a manager is materially underperforming his or her benchmark. But before we get to that stage there are usually a few things we look at first. The first step is usually to look at what the manager owns—individual securities and sectors—and see if there are any obvious culprits. At the same time, we’ll look for any changes at the firm that might be causing problems: turnover among the analysts or portfolio management team, asset growth (and all the associated problems that often come with it), business distractions (e.g., changes in corporate management), and other meaningful changes that may represent a growing or long-term problem.

If the underperformance is unusually large, our research service will call the manager to discuss the causes, review their theses for how the portfolio is positioned, why they own certain stocks, etc. These conversations are not aimed at second-guessing the manager’s judgment, but rather are intended to assess their thinking process and conviction. If satisfied with the manager’s answers to our questions, and if we’re confident that our reasons for buying the fund in the first place are still valid, we are comfortable sticking with the fund through an extended period of underperformance—potentially even a few years’ worth. If the underperformance continues, we will continue to closely monitor the fund and revisit all of the aforementioned questions.

We believe this process helps us to avoid one of the biggest mistakes investors make: selling a good investment while it’s in a slump, then missing the eventual recovery. Every manager goes through slumps. Aside from the anecdotal evidence we’ve seen among the funds we follow, we’ve taken a broader look at other top-performing funds, and there is good evidence that nearly all of their managers have had stretches of underperformance that lasted three years. In a meaningful percentage of these cases, the degree of underperformance was quite large. (This research will be the topic in one of our upcoming monthly commentaries.) The moral of this story is that when a fund is underperforming, we need to understand whether the underperformance is likely to be temporary, or if it’s something more serious that undermines our original investment thesis. During these periods of poor performance, a big part of our process is evaluating whether the fund is indeed still a good investment. If it is, we want to continue owning it. If it’s not, we ’re prepared to move on.

Would you ever shift your bond exposure to a longer-duration fund? How would you decide? Is there a specific interest-rate level that would trigger a change?

We may at some point consider switching our fixed-income exposure to a longer-duration fund. That decision would be based on weighing a number of factors to understand the risk/reward trade-off including the overall portfolio impact. We would need to assess the risk of materially higher rates at the long end of the yield curve. A large increase in rates subsequent to extending our duration would obviously not be a positive outcome. We would also need to assess the potential benefit we would gain from extending duration. If there is a positively sloped yield curve we would pick up incremental yield. That by itself would probably not be enough justification. If we believed rates were nearing a peak and were likely to decline, we would stand to capture larger capital gains than would otherwise be the case. But rate moves are difficult to predict so we would have to be able to make a very convincing case to take that bet. If we were concerned about recession and/or deflation risk, long bonds would provide more portfolio ballast in an environment that would probably be unpleasant for stock prices. Most likely it would take a combination of the above factors to justify a move to a long-duration bond fund.

At present we suspect that we are getting near an interest-rate peak; this is largely the consensus view. And the excess of labor and manufacturing capacity raises the risk that the next recession could trigger an outbreak of deflation. So this is something we have begun to think about, though a move is not imminent.

What is the significance of the carry trade to market risk and does it impact your risk analysis?

The carry trade refers to borrowing at low interest rates in order to invest in higher-yielding investments, thereby capturing the spread between the return and the borrowing cost. The carry trade is usually popular when the yield curve is steep or when there is a significant differential in interest-rate levels around the world. In recent years, low interests rates in Japan and a weak yen (until about a year ago) facilitated a large volume of carry trades—often by hedge funds.

The significance of the carry trade is that it presents a risk factor to financial markets and the global economy. If liquidity quickly dries up, eliminating sources of cheap money, investors will race to exit their high-yielding assets and pay off their debt. This race is exacerbated by the tendency for hedge funds to invest in many of the same markets—making those markets susceptible to a run on the bank. In this financial game of musical chairs, the investors who don’t exit early get stuck with lower-priced assets that result from all the selling. Some emerging markets, high-yield bonds, even REITs are asset classes that could be hurt. In the extreme, this environment could trigger a flight to quality that is bullish for high-quality liquid assets but bearish for everything else.

One problem with the carry trade is that it is hard to assess how widespread it is and the risk of it being unwound quickly. Some people we have talked to believe that the carry trade has been gradually (rather than quickly) unwinding for some time now, but it is not clear how much is still left. Reducing the volume of carry trades lowers the risk of an adverse market impact if a race to unwind the trade develops. The Fed’s telegraphed and gradual increase in interest rates also probably encouraged an orderly unwinding to the extent that there were some carry trades based on the U.S. yield curve. At this point, the damage from a sudden unwinding of the remaining carry trade may not be broad-based, since it is the most overvalued asset classes that are most likely to be hurt. In the end, however, this is not an area where we are able to make a highly confident assessment.

With respect to our portfolios, we do not have much exposure to assets with limited liquidity that we believe would be directly hurt by a disorderly unwinding of the carry trade. We do own emerging markets short-term instruments but, because these are short term, the risk level is not high (their prices in local currency don’t move around much). It is possible that a sudden unwinding of existing carry-trade assets could hit emerging markets hard, temporarily putting pressure on currencies. If that happened, these assets would be impacted. However, we don’t think this is a likely outcome and longer term, regardless of the carry trade, the strong economic fundamentals in many emerging markets suggest to us that those currencies are likely to appreciate in value.

Can you address your willingness to consider emerging-market equities as a separate asset class in your portfolios?

There are two points to address as part of this question: whether emerging markets might be added to our neutral allocation, and if not, whether we may make a tactical bet on emerging markets at some point.
Emerging-market equities is an asset class that we don’t include in our “neutral” allocation. There are a number of criteria (e.g., a long return history) that we require for an asset class to be considered for inclusion in our neutral allocation, and emerging markets fall short on most. That is unlikely to change in the foreseeable future though we have discussed the possibility and may reassess the pros and cons.

Regardless of whether an asset class is part of our neutral allocation, we can still take a tactical position if we view it as sufficiently compelling (a “fat pitch”). With respect to emerging markets, we haven’t taken a tactical position in recent years (though it would have been nice for returns if we had) for a number of reasons, including: difficulty in coming up with a good valuation baseline (because of the limited history), evaluating fundamental economic risks, and assessing whether there were enough “investable” stocks (e.g., adequate liquidity, capable and honest management, good fundamentals) to offer a large enough universe for a dedicated emerging-markets fund. We were also influenced by the fact that the international equity funds we use can and do have some emerging-markets exposure. So, we could, in essence, delegate this decision to our international equity managers. (One problem with this view has become more apparent in recent years—many international equity funds limit their emerging-markets research to a small group of large companies in a somewhat limited group of emerging countries. So many international equity funds don’t offer an ideal way to gain emerging-markets exposure.)

Over the last year or so we have increased efforts are being made in researching and analyzing the emerging-markets asset class. We do believe that fundamentals have improved markedly since the late 1990s and on the surface valuations look reasonable despite the big performance run-up. On the other hand, we are always wary of investing in any asset class that has moved as far and as fast as emerging markets have the last few years. (They compounded at 46% over the three years ended this March 31.) As our emerging-markets research efforts continue, and our ability to assess this asset class improves, it is more likely that at some point in the future we will be in a position to act if we think a fat pitch opportunity arises.

— Stapp Financial Planning, PLLC

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