Third Quarter 2006
Stapp Financial
Investment Letter
Quarterly Investment Commentary
Returns were generally good in the third quarter. Some stock indexes are finally reaching record levels first touched over six years ago (though the NASDAQ remains far below its peak). The larger-cap S&P 500 index ended up 5.6% for the quarter. Small caps were nearly flat, gaining 0.4%. Value outpaced growth across all market caps. Domestic investment-grade bonds and international stocks were each up about 4%, while short-term local currency emerging-markets bonds gained almost 3%. Commodity futures had the worst quarter by far, losing 6.5%. Our model portfolios trail their benchmarks year to date, but continue to outperform over longer time periods.
Review of Equity Valuations
With oil prices dropping and the Fed finally pausing after a lengthy string of rate hikes, the markets have had a nice run in the past few months. From its most recent bottom in mid-July, the S&P 500 is up almost 9%. Normally a rising stock market makes stocks more expensive, but earnings have also been positive over this stretch, which have kept valuations from changing as much as one might think. Our valuation model estimates that the S&P 500 is roughly 20% below fair value. Several other approaches we look at tell a similar story, and even the more conservative of these valuation methods suggest the market is at worst in a fair-value range. (This is not to say that all experts believe the market is undervalued—some do not—but they generally use quite different valuation methods in which we have less confidence.)
Why do stocks measure as being cheap right now? Investors seem to believe that a significant economic downturn is likely enough that they are pricing stocks based on a potentially big decline in earnings. There are many factors that could contribute to declining earnings going forward—a housing-induced recession, under-funded employee liabilities such as pensions and health insur-ance, and even a simple reversion to normal profit margins—but it’s really only a perfect storm that would cause earnings to drop so much and/or over so prolonged a period that it would justify current valuations.
The stock market is not always right (we are reminded of the quip about the market having pre-dicted nine of the last five recessions) and if it is wrong then stocks really are undervalued. But, in our view, broad risk levels are higher than average right now, and we are no different from the rest of the market in that these risks impact our enthusiasm for stocks. In addition to the above-mentioned factors, there remain problems associated with our current account and federal budget deficits, the looming threats of Social Security and Medicare liabilities, high levels of consumer debt, and the continuing risk of an economically damaging terrorist attack (to name a few). These bigger-picture risks are on top of normal cyclical risk; with the economy slowing and the housing market deteriorating rapidly, recession risk has risen. These risks are material enough to make us more cautious than we otherwise would be in deciding whether to overweight equities.
On the positive side, it is entirely possible that the U.S. economy will have a soft landing and con-tinue to expand for several years, and we are always pleased when stocks are priced with a big valuation cushion, since this reduces our downside risk (most bear markets, for example, start from a point of high valuation). As long as stock prices are factoring in a higher risk premium, stocks will continue to look cheap relative to valuation comparisons over the past 25 years. However, if investors’ risk perceptions improve, the resulting higher valuations would drive a spike in returns (all other things being equal).
Among other equity asset classes, foreign stock valuations are in line with their historical average relative to the U.S., and we remain at neutral weightings. Among domestic equities, growth stocks look slightly cheap relative to value stocks on a statistical basis, an opinion which has also been voiced by many of the managers we respect. In both cases, we are comfortable letting our managers make the decision as to which specific stocks represent the best investment opportunities in those areas. The one equity area we find sufficiently compelling to take a tactical weighting is in the valuation relationship between larger-caps and smaller-caps.
Explanation of Our Smaller-Cap Reduction
Last month we reduced the small-cap exposure in our portfolios and moved the proceeds into large-caps. In reaching this decision, we looked at data from several sources, and in every case these metrics showed small-cap valuations at or near the high end of their historical range relative to large-caps. The chart below shows the historical relationship between large-cap and small-cap P/E ratios. A ratio of ratios may be difficult to get one’s arms around, but it’s worth understanding. A P/E ratio on its own tells us how much it costs to buy a dollar of earnings: a higher P/E ratio means you are paying a higher price for that dollar, and a lower P/E ratio means you are paying a lower price. This chart is nothing more than a way of comparing the “costliness” of large-caps and small-caps to one another based on their P/Es. As an example, if a dollar of earnings from the aver-age large-cap company cost $18 (which is a P/E of 18x) and a dollar of earnings from the average small-cap company cost $20 (a P/E of 20x), then the “ratio of ratios” would show that large-caps cost 90% of what small caps cost (18 divided by 20 is 0.9). Right now, this data shows that small-caps are expensive relative to large-caps. In fact, they are nearly as expensive as they’ve ever been, an observation supported by other data sources as well.
We
also believe that cyclical considerations favor a lower small-cap weighting.
We’re well into the economic cycle, and small-caps’ best
periods of relative performance typically come early in the cycle. Combined
with the valuation backdrop, we think the odds are very good that large-caps
will beat small-caps on average over the next five years.
We want to emphasize that our basis for underweighting smaller caps is
relative. Larger-caps are not necessarily a compelling absolute return
opportunity on their own, but smaller-caps are clearly less attractive
than larger-caps, and as such we want to shift our asset allocation accordingly.
Our overall equity exposure remains unchanged. We also caution that there
is no way to know for sure how long it will take for this move to pay
off. Our confidence is based on a longer time frame, one that could be
as long as five years, but it is impossible to successfully predict the
short term.
The Economy and Bonds
Thanks to slowing earnings, dropping oil prices and a deteriorating real estate market, the Federal Reserve has finally put on hold what has turned out to be one of the sharpest cycles of rate in-creases on record. Economic forecasting is extremely difficult, but it’s pretty clear that the risk of re-cession is greater today than in recent years. For us, that means we need to manage our portfolios with an eye towards this risk, as well as others. High-quality bonds are generally the best-performing asset class during recessions, and as such we believe bonds still have an important role to play in balanced portfolios (bonds help mute the volatility of equities in other scenarios as well). The bottom line is that we don’t need to be able to forecast the economy with precision in order to make sound portfolio decisions.
We also own emerging-market short-term local-currency bonds as a tactical hedge against a dollar decline. At almost 6% of GDP, the U.S. current account deficit remains near its worst level in his-tory. Foreigners’ demand for our financial assets has, to some degree, offset our demand for their goods and services, and that has mitigated the dollar’s decline over the last several years. The dollar did decline a significant amount between 2002 and 2004 against a basket of major currencies, so a partial correction of this imbalance has started, but the dollar has declined far less relative to “other important trading partners,” a group defined by the Fed that includes China, Mexico, and much of Latin American and Asian emerging markets. The fact that the current-account deficit, which is mostly driven by our trade deficit, remains at an all-time high is further validation that the dollar’s declines thus far have been insufficient to correct this imbalance. To us, this suggests that on a long-term basis, the dollar is likely to experience further declines. This is the most important argument underlying our position in emerging-market short-term local-currency bonds. These bonds have higher yields than U.S. bonds of similar maturity, which is an additional argument in their favor, along with the improving fundamentals in many emerging-market countries.
In the event of a sharp and disorderly decline in the dollar, emerging market currencies could come under selling pressure because of their closer ties to the dollar and a broad move away from riskier economies. Developed-market foreign bonds could certainly do better in that situation, but are con-siderably less attractive in a base-case scenario for several reasons: their lower nominal yields; the fact that most of their currencies, with the exception of the yen, have already had big moves versus the dollar; and that as a group they don’t represent some of the countries with which our largest trade imbalances exist. It’s a balancing act, but we continue to believe that emerging-market short-term local-currency bonds provide valuable diversification and the potential for very good long-term returns relative to domestic bonds.
We continue to own small positions in commodity futures in our balanced accounts. At present, we believe the return prospects for commodity futures are not as good as equities, but are better than bonds (and they provide a valuable diversification benefit when mixed with stocks and bonds). As a result our small positions in this asset class are coming out of our bond exposure.
Conclusion
We are pleased that there are tactical opportunities in short-term emerging markets bonds, com-modity futures, and larger-caps versus smaller-caps in our portfolios. We are confident these moves will modestly improve our return prospects while helping mitigate certain risks over coming years. That said, there are still no compelling, purely return-based opportunities at this time. The fact that several of our managers have trailed their benchmarks at the same time hasn’t helped, and as a result our performance has lagged this year after a long stretch of outperformance. The shorter-term underperformance of our managers does not impact our confidence in their ability to beat their benchmarks over the long term. Over the years we have often observed and commented that even top managers occasionally have lengthy and sometimes significant stretches of underperformance. The managers we use are chosen based on extensive due diligence, and we follow up with them frequently. As long as our original thesis remains intact, and there are no material issues that im-pact our confidence in their investment edge, we know that underperformance is not by itself a rea-son to make a change. Even the greatest managers will at times test their investors’ patience, but as in all investing, patience and discipline are keys. At the asset class level, we will remain patient as well, and when the inevitable mispricing provides us with a compelling return opportunity, we will be ready to take advantage of it.
We thank you for your confidence and trust.
Stapp Financial Planning, PLLC
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