Third Quarter 2005
Stapp Financial Investment Letter
Quarterly Investment Commentary
Equities have seen tepid returns year-to-date, but did relatively well in the third quarter. The S&P 500 rose 3.6% and the small-cap Russell 2000 gained 4.7%. REITs picked up 3.8% on top of a very strong prior two quarters. Foreign stocks did very well, gaining 11.7%, as did commodity futures (up almost 17%) due in large part to soaring energy prices. Investment-grade bonds were slightly in the red, while foreign bonds did slightly worse due to appreciation in the U.S. dollar. For the quarter, our equity managers on average held their own against their benchmarks, while our overall tactical positioning in balanced models added value and contributed to their outperforming their benchmarks.
Market Overview
Stocks — There is plenty to worry about these days: hurricanes, housing prices, massive current-account and federal-budget deficits, strife in Iraq, rising inflation, and others. We share these con-cerns, and spend much of our time evaluating how these risks could impact the U.S. economy and markets in the near and long term. It’s tempting to give in to these fears and assume a conservative investment posture, but this would ignore another—and perhaps more important—variable, which is valuations. Valuations matter because they provide insight into what the market expects to hap-pen, and sometimes those expectations are overly optimistic or overly pessimistic. When these situations occur, we can take advantage of these opportunities and reposition our portfolios to po-tentially enhance our long-term returns, without increasing overall portfolio risk. In fact, in some instances, such as when there is a fat-pitch opportunity, overall portfolio risk may be reduced.
Looking at the current market and using several different valuation methodologies, it appears that the S&P 500 is at the low end of what we considered to be a fair-value range. These valuation approaches assume an average level of risk relative to history. So if there are no major blow-ups or there is no major cyclical downturn, we’d expect average annual returns somewhere in the high single-digit range over the next five years. The market always prices in risk to some degree, but it seems likely that the market is presently pricing in a somewhat greater-than-average level of risk. We too believe that there is a higher-than-average level of risk right now, but this valuation buffer gives us some comfort that investors are not ignoring these risks. In the short-run, valuations sel-dom come into play as a backstop against losses; investors get scared and head for the exits, valua-tions be damned. However, the trade-off for that short-term pain would be that it would create an opportunity for better-than-average long-term gains.
Within the equity universe, we aren’t seeing any attractive tactical opportunities. International eq-uities have several things going for them: improving fundamentals in some areas such as Japan and emerging markets, and higher dividend yields and slightly better valuations than in the U.S. But we see risks as well: poor decision-making by government policy makers, sluggish progress on struc-tural reforms, dependence on U.S. demand for exports, etc. On balance we prefer to stick with our neutral weightings and let our international fund managers sort out the best places to buy stocks. The continued strong upward move in commodity futures prices has probably reduced some of their return potential (at least over the short term). However, the primary structural elements of to-tal return for the commodity futures index (and the PIMCO Commodity RealReturn Fund) remain, and there are many plausible scenarios where commodity futures will perform either as well as or much better than the 60/40 mix of stocks and bonds with which we funded the position. Commod-ity futures would likely do poorly in a deflationary environment, but over the long-term we still be-lieve this investment will add value.
Fixed Income — Investments in the fixed-income world can be very tricky. For example, rising oil prices stoke fears of inflation, which is bad for bond prices, but at the same time there are concerns that high oil prices in conjunction with other factors (such as a slowing housing market) could slow economic growth, which is good for bond prices. While economic forecasting is difficult, and call-ing turning points is even tougher, we don’t have to be able to forecast that environment to intelli-gently factor fixed income into our portfolio weightings.
In deciding how to allocate to bonds it is important to think about their purpose. Is it to provide in-come? Provide big returns to the portfolios when tactical opportunities present themselves? Our view is that most of the time bonds’ most important function is to help offset equity losses when the markets are in flux. Obviously we are aware of—and sensitive to—the return prospects for different bond sectors, and this plays into our decision-making process, but the key driver is in assessing how they can help us “play defense” when times are tough for stocks. Right now, real yields on in-vestment-grade bonds are very low, which suggests to us that they may be overvalued on a long-term basis. There are several scenarios where, over the short term, rising rates could result in cash outperforming bonds. But if we experience a significant economic slowdown, bonds would experi-ence some appreciation at a time when equity markets wouldn’t be performing well.
So bonds are an important diversifier that help us manage risk. Even with their relatively low yields we expect them to generate returns in the 4% to 5% range, which would equal or outperform cash returns over the long run in most scenarios, including a “steady-state” environment in which we don’t see any huge changes in economic conditions. Our thinking on this has evolved recently, and is discussed more below. We also continue to believe foreign-currency denominated bonds are a prudent investment, although we are making some changes in these positions as well (also dis-cussed below).
New Allocations for Our Balanced Portfolios
We are making two moves in our model portfolios this month: First, we are replacing our alloca-tions to foreign bonds one-for-one with positions in PIMCO’s new Developing Local Markets Fund. Essentially, this move maintains our exposure to foreign currencies, but does so in a way that we think offers a better risk/return profile to the portfolios than what we would get with bonds from developed countries. At the same time, we are eliminating our dedicated cash allocations and re-turning the proceeds to standard investment-grade bonds.
PIMCO Developing Local Markets — The decision to swap into PIMCO Developing Local Mar-kets (DLM) is something we’ve been considering for several months. Since we originally estab-lished our foreign bond positions in early 2004, several important factors have changed. The rela-tive yield advantage we once enjoyed overseas is no more. Also, the difference in real (inflation-adjusted) yields has narrowed, suggesting that foreign bonds no longer have a valuation advantage over U.S. bonds. Additionally, the dollar may not be as overvalued as it once was in relation to sev-eral developed regions, Europe in particular. However, because of the unprecedented magnitude of our current account deficit, we continue to believe a dollar depreciation versus the currencies of some of our larger trading partners is probable over the long run, and there is a small risk of an outright dollar crash at some point if overseas investors unexpectedly decide to diversify or reduce their U.S. holdings, sparking a “rush for the exit.”
A few months ago, PIMCO launched the DLM fund, (the first public mutual fund of its kind) which invests primarily in ultra-short-term bonds in a wide range of emerging markets. These countries offer yields which are attractive in both nominal and real terms relative to the U.S. and developed markets; this fund’s benchmark, the JPMorgan ELMI+ Index, currently yields roughly 5.5%. Also, the long-term economic fundamentals in many emerging markets have improved markedly (lower debt levels and higher foreign currency reserves, for example), and given this improvement, along with trade flows, we believe that over a period of years the dollar is more likely to experience mate-rial declines against these countries’ currencies than against more developed markets’ currencies. (These improved fundamentals also contribute to the attractiveness of the ELMI universe, although this in and of itself would not be a sufficient reason to invest there—it’s just one of several factors that we view as a positive.)
Because of the fund’s very short duration—it is almost like a money market—there is no significant interest rate risk, although there is still the currency risk. The currency risk should not be ignored as a very real source of volatility, but the fund is extremely diversified with a wide range of emerging markets, and in the past this diversification has been surprisingly effective at mitigating downside risk. That doesn’t mean there isn’t risk—even in emerging markets yields are quite a bit lower than they were a few years ago and this means less cushion against capital losses, for example—but as noted the fundamentals are also markedly better. Finally, PIMCO’s DLM fund in particular offers an advantage versus their developed market bond funds in that it has considerably more flexibility to make moves away from its benchmark. Ordinarily, this is not something we look for when mak-ing tactical asset allocation decisions, but in the case of emerging markets—where meaningful risks can come from a small number of countries—we think PIMCO’s proven track record could add a meaningful amount of value; their Emerging Markets Bond Fund has a great record over the eight years since its inception.
Eliminating Cash — The decision to eliminate our dedicated cash positions is largely a function of scenario analysis, rather than a valuation call per se. Admittedly, it is a relatively small change that has only a marginal impact on the portfolios, but we want to explain the logic behind this decision nonetheless. Cash yields have been on the rise, while bond yields have moved comparatively less, which on its face suggests that cash is even more attractive now than it was when we first estab-lished these positions two years ago. However, in actually penciling through a wide range of sce-narios—factoring in other investments we hold—we came to two conclusions: First, over a five-year time horizon, it’s very unlikely that cash will outperform bonds. Second, in looking at our overall positioning, we would like to have more recession/deflation protection than what is currently pre-sent in our portfolios. In the event of a bad recession, commodity futures, Loomis Sayles Bond Fund, FPA New Income, and cash are all likely to provide less ballast than a more conventional bond fund like PIMCO Total Return. Furthermore, the shift from developed market bonds to emerging markets cash contributes even more to this imbalance. Effectively we’re making a bet against a recession/deflation scenario in the near term that is stronger than what we believe is called for given our overall long-term market views.
In looking at our options, we believe eliminating the cash positions in favor of PIMCO Total Return marginally reduces this implicit bias. The biggest risk to making this move right now is that short-term interest rates continue to rise, causing bond prices to drop. The good news is that the perform-ance differential is not likely to be huge either way, and we’re positioning our portfolios in a way that protects them better in the event of a sudden recessionary shock, which poses a more material downside risk.
In carefully assessing a range of possible economic scenarios, we recognize that in a worst-case sce-nario, we would violate our loss thresholds. The problem is that the only way to completely hedge this risk is to have very low allocations to volatile investments such as equities. But even bonds are not a perfect solution (we can imagine bonds losing 5% or more in a dollar crash or stagflation sce-nario, and they could even lose money if the economy did unexpectedly well). That leaves few op-tions other than cash, which under any circumstance does not offer attractive long-term returns. So trying to protect against all possible risks would result in a permanent, ultra-conservative asset al-location. That level of excessive pessimism can be just as detrimental to long-term returns as market disruptions: missing big up-moves can seriously reduce long-term average returns. We own things like bonds, commodity futures, and foreign bonds to help us in the event that some of these risks come to pass, but we have always been willing to accept a small chance that risk thresholds could be violated by what we believe would be a small amount in certain very severe scenarios. As al-ways it is very important to make sure you are in the right type of portfolio for your level of risk tolerance.
We thank you for your confidence and trust.
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