First Quarter Investment Commentary
April 19, 2013
of Litman Gregory
FIRST QUARTER 2013 KEY TAKEAWAYS
U.S. stocks posted robust gains in the first quarter, beating both developed international stocks—which overcame worrisome developments in Europe to return 4%—and emerging-markets stocks, which lost 4%.
Our portfolios faced three market headwinds as a result of our positioning: Our balanced portfolios are tactically underweight stocks and overweight lower-risk asset classes and investment strategies. Within our stock exposure, we are tilted away from U.S. stocks toward emerging-markets and developed international stocks. Within our U.S. stock exposure, we are tilted away from small-cap stocks toward large-caps.
On the positive side, our actively managed bond funds continued to add value relative to the core bond index. And our tactical position in floating-rate loan funds also added value.
Supported by an accommodative Federal Reserve, U.S. economic fundamentals have continued to grudgingly improve. Unemployment is slowly falling, home prices have been rising, and corporate earnings and profitability are near record highs. Fed actions have also continued to support—and drive—strong U.S. stock market gains.
Looking ahead, significant uncertainty surrounds fiscal and monetary policy in terms of what policies will be adopted and their ultimate economic and financial market impacts. More broadly, still-high global debt levels pose an economic headwind.
Against this backdrop, our outlook for stocks has not improved. If anything, given the sharp run-up in stock prices, we are getting closer to reducing our U.S. equity exposure further than we are to increasing it.
We continue to find emerging-markets stocks attractive, both relative to U.S. stocks and in absolute terms over our five-year time horizon.
Most parts of the bond market offer paltry longer-term return potential, particularly given our expectation for rising rates over our five-year investment horizon and we continue to favor actively managed bond funds.
U.S. stocks moved sharply higher in the first quarter, with both the Dow Jones industrial average and the S&P 500 hitting new all-time highs (in nominal terms). The Vanguard 500 index (our S&P proxy) gained 11% for the quarter, while smaller-cap stocks shot up by 12%. Despite worrisome developments in the eurozone, developed international stocks gained roughly 4%. Not all risky assets performed equally well, however. Emerging-markets stocks were down 4%. So the U.S. stock market was a huge outperformer.
The yield on core investment-grade bonds rose slightly in the first two months of the quarter, with the 10-year Treasury yield moving from 1.8% at year end to over 2%, before ending the quarter roughly where it started. (The 10-year yield last touched 2% in April 2012.) The Barclays Aggregate Bond Index yield, our benchmark for core bonds, yielded close to 1.8% at the end of the quarter compared to just below 1.6% at year end. So in terms of total return, both Treasurys and the Vanguard Total Bond Market index (our Aggregate Bond Index proxy) ended flat for the quarter. Municipal bond returns were also flat for the quarter. Developed foreign bonds were down 3%, due in part to currency weakness against the U.S. dollar. Emerging-markets currencies also declined in aggregate, eating into the higher yields generated from local sovereign bonds, which ended flat for the quarter. Floating-rate loans have moved modestly higher year-to-date, up just over 2%.
Broadly speaking, our portfolios faced three market headwinds in the quarter as a result of our positioning: Our balanced portfolios are tactically underweight stocks and overweight lower-risk asset classes and investment strategies. Within our stock exposure, we are tilted away from U.S. stocks toward emerging-markets and developed international stocks. Within our U.S. stock exposure, we are tilted away from small-cap stocks toward large-caps.
On the positive side, our actively managed bond funds continued to add value relative to the core bond index. And our tactical position in floating-rate loan funds also added value versus the core bond index. Our actively managed stock funds had mixed performance, but overall look to have performed roughly in line with the stock market indexes for the quarter (based on our preliminary analysis).
What Now for U.S. Stocks?
With U.S. stocks hitting new highs, we are naturally getting two questions from clients:
- With stocks up so much, shouldn’t we reduce our exposure (to lock in gains, given all of the big picture risks)?
- With stocks up so much, shouldn’t we increase our exposure (since the economy must be much better than people expected)?
These are both good questions and not unusual among investors today. They can also provide a good jumping off point for advisors to discuss (and reassess) a client’s true risk tolerance, mindset, and investment objectives. Our short answer to both questions right now is, no.
The longer answer is that our outlook for stocks has not improved, and, if anything, given the sharp run-up in stock prices, which implies lower future returns over our five-year tactical horizon, we are getting closer to reducing our U.S. equity exposure than we are to increasing it.
As our clients know, our assessment of the potential risks and returns for stocks is based on looking across a range of scenarios that we think are at least reasonably likely to play out, as well as considering more extreme negative scenarios that we believe are lower probability, but hold serious negative implications (at least over the shorter term) for risky assets like stocks. This downside stress-testing is critical because most of our portfolios are managed against a 12-month downside loss threshold. But that must be balanced against our longer-term (five-year) framework for assessing potential returns across asset classes.
So we find ourselves still in the position of viewing the upside return potential of the U.S. equity market as insufficient to compensate us for the downside risks of owning U.S. stocks. However, we also believe there is an unusually wide range of possible outcomes for economic fundamentals and hence the market. This includes some positive scenarios for U.S. stocks (with annualized returns in the low double digits), as well as some severely negative outcomes as the U.S. and the entire global economy works through the aftermath of the financial/debt crisis of 2008. While we believe the weight of the evidence tilts more toward the left side (the worse side) of the distribution of possible outcomes, the reality is that we do not have a high level of conviction in any one particular scenario playing out.
Our lack of confidence in our ability to predict precisely which scenario will unfold, and invest accordingly, could strike some as hedging our bets or even being wishy-washy. Our response is that we are hedging our bets to some extent—also known as diversifying —and that is the prudent thing to do in an environment this uncertain. We are constructing portfolios that we believe should perform reasonably well across a range of potential outcomes, any one of which we believe has reasonable odds of actually playing out. But if one of the more extremely negative or positive scenarios unfolds, our portfolios are not going to do as well (at least over the shorter term) as a portfolio that has made a big bet on that particular outcome. Of course, if a particular extreme scenario doesn’t happen, then those extremely positioned portfolios would experience commensurately poor performance. We don’t think making a big bet on an outcome that can’t be determined with confidence is in the best interests of our clients.
Two Keys to Our Long-Term Investment Success
One of the most important aspects of our job as analysts, portfolio managers, and investment advisors is not to fool ourselves. As the great physicist and thinker Richard Feynman said (in a different context), “The first principle is that you must not fool yourself—and you are the easiest person to fool.” While we are always looking for fat pitch investment opportunities that we’re convinced can generate additional value for our clients, we need to be intellectually honest with our clients and ourselves when we don’t have a sound basis for such conviction.
This relates to a second critical element in the long-term success of our investment process, but one that is also challenging for many investors: patience. We need to remain patient in waiting for the rare, truly high-conviction opportunities to present themselves, which they inevitably do. And also, once we have taken a high-conviction position, we must allow time (often years) for it to ultimately play out, particularly in the face of shorter-term market moves against us. Directing our efforts toward both intellectual honesty and patience has been key to our longer-term success.
A major contributor to the uncertainty we face in today’s environment surrounds government policy, both fiscal and monetary, specifically what policies will be adopted as well as their ultimate economic and financial market impacts.
With respect to fiscal policy, in the first quarter the markets digested the sequester’s spending cuts without much drama. But the sequester’s impact (estimated at around a 0.6% hit to GDP growth in 2013) is small potatoes compared to the debt and fiscal policy challenges that still confront the nation. Although we would agree that there is not an immediate federal budget deficit crisis, and that there is a real risk of snuffing out what remains a weak economic recovery with too much near-term fiscal austerity, there is clearly a debt/deficit crisis, at least in the medium to longer term, given the mismatch between federal revenue and spending. This calls for a strong and credible longer-term fiscal policy response, and the sooner the better. We won’t hold our breath, but maybe our political leaders in Washington are starting to get the message. If so, that could be a major positive catalyst for both the financial markets and the real economy. On the other hand, it may yet take a crisis to create the political will necessary to implement meaningful structural fiscal changes.
On the monetary policy side, there is more clarity at least in terms of the policies already in place. The leadership of the Federal Reserve (Chairman Ben Bernanke and Vice Chairman Janet Yellen, among others) continue to be very vocal in stating that the Fed is not close to starting to unwind their stimulative policies, which involve purchasing $85 billion per month of Treasury bonds and mortgage-backed securities (quantitative easing) and holding the federal funds policy rate near zero percent. But there is significant uncertainty as to the medium- to longer-term ramifications and unintended consequences of these policies and whether or not the Fed’s ultimate exit plan will be executed successfully and without collateral damage. Based on the Fed’s historical record of policy overshooting—and just the inherent complexity of the task at hand for anyone to get it right without a lot of luck—most, including us, are skeptical.
In the meantime, Fed statements and actions continue to be an important support and driver of short-term stock market performance. While central bank actions have always influenced the stock market, the markets appear particularly attuned to and reliant on ongoing highly accommodative Fed policy. Again, over the near term, we don’t see any catalyst for Fed policy to become restrictive. So that leg of support to the markets is likely to remain in place. But the uncertainty increases as the time horizon extends, and our confidence in our ability to be “ahead of the market” in assessing a change in Fed policy and repositioning our portfolios accordingly is very low.
Modestly Improving Economic Fundamentals
Supported by accommodative monetary policy, U.S. economic fundamentals have continued to grudgingly improve. The unemployment rate continues to slowly fall, although that’s partly driven by a particularly sharp drop in the labor force participation rate, meaning there are fewer people working or seeking work, which is not a good thing. The housing market is strengthening, although mortgage lending to households remains tight, and household wealth is growing, driven by stock market and housing price gains—a key goal of the Fed’s QE program. Finally, corporate earnings and profitability are around their all-time highs. (That said, S&P 500 earnings growth in 2012 was actually slightly negative for the year; the market’s 16% return in 2012 came from stock valuations getting richer, not profit growth.) But our concerns about the impact of global debt-deleveraging on economic growth and corporate profits remain. In our base-case subpar-recovery scenario, the still huge debt overhang is a significant headwind to economic growth, and in a worst-case scenario it leads to another financial crisis.
Our Analysis Indicates U.S. Stocks Are Not Attractive
With this backdrop, we felt it would be useful to outline the key elements of our analysis of potential U.S. stock market returns. We offer this both as a review and update for those familiar with our approach and as context for our stock market return expectations (particularly because our expected returns may seem low relative to some strategists). [ For those seeking greater detail on each of our building blocks outlined below, please see our sidebar article, Further Detail on our U.S. Equities Analysis. ]
The three primary building blocks for our five-year estimates of stock market returns are 1) earnings growth, 2) valuation (price/earnings) multiples, and 3) dividend yield. We consider a range of broad economic scenarios that we think have a reasonable likelihood of playing out over the next five years. We then derive assumptions for earnings growth and valuations for the S&P 500 that we believe are consistent with each scenario. These assumptions are based on our analysis of the past 90 or so years of stock market and economic history in conjunction with our forward-looking assessment that incorporates differences between the current environment and prior economic and market cycles. Of course, there are always differences between the present and the past, which makes this exercise one involving judgment, experience, and a blend of qualitative and quantitative analysis, rather than simply mining historical data and extrapolating trends.
Related to this is the importance of not falling victim to “false precision,” i.e., believing (fooling yourself) that it is possible to precisely predict these key variables five years from now. But if we can be approximately right in our estimates, apply our assumptions with consistency, and remain disciplined in our process and patient in waiting for a fat pitch opportunity, we can add value over the long term.
Based on our analysis of potential returns across our entire range of scenarios, we have concluded that an underweight to the U.S. equity market is warranted. However, and importantly, our portfolios still maintain significant exposure to U.S. stocks because our analysis suggests that stocks should perform at least reasonably well across a meaningful portion of our potential return range, both in absolute terms and relative to other competing asset classes and strategies in which we could currently invest.
European Stocks: We Unwound Our Tactical Position in March
In June 2012, we established a small tactical position in European stocks because we viewed their valuations as depressed, with potential upside more than sufficient to compensate us for the potential downside risks over our five-year tactical investment horizon. Our short-term timing proved prescient (i.e., lucky) and European markets went on to significantly outperform U.S. stocks for the remainder of the year. Earlier this year, as European valuations and relative returns became less attractive we re-evaluated our trigger point for selling the position and concluded that there was still sufficient (although diminished) upside to remain holders of the position.
However, with the recent proposal to tax insured bank deposits in Cyprus, our assessment of the relative risk and return changed. Our expected returns for Europe came down further and no longer offered an adequate return premium in our view. So we eliminated our tactical position in the European stock index ETF. (Please see our trade commentary for more details on this March 21, 2013, change.)
Rather than add the proceeds from our sale of Europe stocks back into U.S. stocks, we allocated the proceeds to emerging-markets stocks, where we continue to see more attractive absolute and relative returns (as we discuss further below).
Our Analysis Indicates Emerging-Markets Stocks Are Now More Attractive
First, as we noted at the beginning of this commentary, emerging-markets stocks underperformed U.S. stocks significantly in the first quarter. This led to an increase of more than two percentage points (annualized) in our relative return expectations for emerging-markets stocks versus U.S. stocks, compared to our year-end return estimates. At current prices, our base case expectation is for very low double-digit returns for emerging-markets stocks, compared to low single-digit returns for the United States. This is a relative return spread that strongly favors emerging markets, even assuming, as we do, that emerging-markets stocks would have worse short-term downside risk than U.S. stocks in a severe recession scenario. Therefore, within our overall equity exposure we are tactically overweight to emerging-markets stocks versus U.S. stocks compared with our strategic emerging markets vs. U.S. relative weighting.
Our framework for estimating emerging-markets stock returns is similar to what we use for U.S. stocks—building the total return from earnings, dividends, and valuation multiples. But in the case of emerging markets there is much less historical data to analyze (and it’s also less reliable data at that), so even more judgment and forward-looking analysis is required.
Our assessment is that emerging-markets stock earnings, in aggregate, are currently near their trend level. As such, our base-case estimated return of 11% is comprised of roughly 7% trend earnings growth (slightly higher than the 5.8% U.S. trend earnings growth), a dividend yield of 2.7%, and a small incremental return from P/E multiple expansion. We believe we are using a conservative end-point P/E multiple for emerging-markets stocks of 13x, which is about a 15% discount to the 15x P/E we assume for the United States in our base case. The lower emerging-markets multiple reflects our assessment of emerging-markets’ higher risks.
Reflecting back on our U.S. equities return analysis, the primary reason why emerging-markets stock returns come out much higher versus U.S. returns across all of our scenarios is that U.S. earnings are well above their long-term trend, whereas emerging-markets earnings are not. A secondary reason is that on a trailing P/E basis, emerging markets are currently trading more cheaply than our ending valuation assumption, whereas in most of our scenarios U.S. stocks are currently at a valuation premium.
In addition to their attractiveness relative to the U.S. market, we also believe the prospective absolute returns for emerging-markets stocks are now sufficiently high to compensate us for their risk over our five-year time horizon. Therefore, depending on the portfolio, we have increased our emerging-markets exposure to or slightly above their strategic target allocations, so that we are no longer tactically underweight to emerging-markets stocks (except in our most defensive balanced portfolio).
The table below shows our current exposure to stocks, including the difference between our strategic target weightings to U.S., developed international (EAFE), and emerging-markets stocks and our current tactical allocations. (Negative numbers indicate we are underweight.)
Update on Bond Markets
Turning to the bond markets, since year-end there has not been much change in how we view risk and return potential. We continue to view most fixed-income sectors as unattractive. The big-picture bottom-line is that the fixed-income marketplace, particularly the highest quality parts, continues to offer paltry longer-term returns, particularly given our expectation for rising interest rates over our five-year investment horizon. Most areas of fixed-income are trading at historically elevated prices, and yield levels are at or near historic lows. For example, at the end of March, the high-yield bond market hit an all-time low yield, falling below 5.8%. Corporate balance sheets generally remain solid and we expect high-yield default rates to remain low for the time being, supporting the current low level of yields. But given that current prices are well above par value and yields are low, our five-year total return estimates for high-yield bonds are too low to compensate us for their downside risks, so we do not own a dedicated tactical position, though our active bond fund managers are still finding some bottom-up security-specific opportunities within high yield. The more conservative parts of the floating-rate loan market where we are invested (BB- and B-rated loans) are on average trading at par. With expected returns in our base case of roughly 4.5% annualized over the next five years, we continue to think loans are tactically attractive for our most fixed-income-heavy portfolios. At the same time, the high-quality aggregate bond index had a yield of approximately 1.7%, well below the 20-year average of closer to 5%. (The all-time low yield is just below 1.4%, which occurred late in the third quarter of last year.) At current prices, our five-year total return estimate for high-quality core bonds is in the very low single digits, and does not provide much compensation against the risk of a sharp rise in interest rates.
Our Fixed-Income Positioning
What this means in terms of our fixed-income positioning is that our balanced portfolios remain heavily underweight to core investment-grade bond funds, at slightly under half of our strategic target weighting. In their place we have large allocations to flexible and absolute-return-oriented bond funds. Core bond funds will generally have more sensitivity to changes in interest rates (known as a higher duration) than the flexible bond funds. This means that if interest rates fall, core bond funds benefit more from the corresponding increase in bond prices, but if rates rise, core bonds suffer larger capital losses from falling prices. With the current core bond index yield so low, we view the risk of damage from rising rates as greater.
Even so, we occasionally get the question (and more frequently ask ourselves) why we don’t have a larger core bond position, given the macro-/deleveraging-/recession-shock risks that we so frequently highlight. If those risks come to pass, core investment-grade bond funds will be the best place to be as investors flee riskier assets—including riskier segments of the bond market—to the safety of high-quality bonds (such as Treasurys and other government-related securities). With more than half of our fixed-income allocation in non-core funds, aren’t we giving up a lot of downside protection in a negative scenario? Furthermore, how does this positioning align with our risk management efforts?
The key to our response to these questions is that one needs to look at our fixed-income exposure in the context of our overall portfolio exposures, in addition to thinking about the relative risk and return of core vs. non-core bond funds. The essence of balanced portfolio management is not to focus on how any individual piece of the portfolio may perform in a vacuum, but how each piece of the portfolio plays a particular role in the overall portfolio, how the sum of the parts will perform across a range of scenarios, and the risk/return profile of the entire portfolio.
To simplify, we can break this analysis into two parts: 1) the potential risks and returns across our positions within the overall fixed-income piece of our balanced portfolios, and 2) how the fixed-income piece fits with the rest of the portfolio, creating a risk/return profile for the entire balanced portfolio.
Within our fixed-income piece we own bond funds that are giving us different, diversified, and varying exposures to three key risk factors: 1) interest-rate risk (duration), 2) credit or default risk, and 3) currency (non-dollar) risk. Each fund has some exposure to all of these risk factors. And because the funds are actively managed, the exposures can and will vary over time based on the managers’ assessment of risks and returns, while remaining within the constraints of each fund’s (different) investment objectives and policies.
We expect our more flexible bond funds to outperform the core bond index (and core bond funds) across our five-year scenarios. This is a function of 1) their inherently flexible investment mandates coupled with the managers’ skill/expertise, and 2) our expectation that rates will likely rise over this time period, which will favor funds that can minimize their interest-rate risk exposure (or even have a negative duration and therefore actually benefit from rising rates). However, we must balance that longer-term return expectation against these funds’ higher exposures to credit and currency risk.
In the shorter term, say over a 12-month period, core bonds could certainly outperform if we have some type of recession shock or surprise. In that event, our tactical position in flexible bond funds will hurt us relative to our strategic core bond allocation. In the severe stress-test scenario where we assume Treasury yields drop, lower-quality bond yields rise (i.e., credit spreads widen), and foreign currencies fall versus the dollar—in other words we assume all of the fixed income risk-factor exposures work against us in the short term—we estimate the negative impact on our Balanced (60% stocks/40% bonds) portfolio (given our current allocations) would be roughly two percentage points over a 12-month period. That is, we estimate that the return to the fixed-income piece of our current Balanced portfolio would be around two percentage points lower in that 12-month stress scenario than it would be if we had our full long-term strategic weighting to core bond funds, instead of splitting the allocation with the flexible and absolute-return-oriented bond funds. We consider that a significant potential cost (downside risk) to owning those funds.
To widen the lens, we must factor in the rest of the portfolio, specifically the non-fixed-income piece that includes our equity exposure, as well as our positions in emerging-markets local-currency bonds and lower-risk alternative strategies. We have already discussed our underweight to stocks that ranges from around 10–15 percentage points depending on the balanced model portfolio. (See table above “Current Over- and Underweights to U.S., Developed International, and Emerging-Markets Stocks by Model Portfolio” showing our overall stock underweight in each model portfolio.) Some of this underweight is allocated to flexible bond funds, and the rest of it is in emerging-markets local-currency bonds and alternative strategies. Again using our Balanced portfolio as an example, in the severe stress test 12-month scenario we estimate the positive impact from our tactical underweight to stocks would be roughly two-and-a-half percentage points.
We are wary of false precision and know our estimates won’t be exactly right. But we are comfortable saying the risk exposures from these two pieces of the portfolio should roughly offset each other in a severely negative scenario. (In other stress test scenarios where, for example, rates rise sharply or the dollar drops sharply, our flexible bond funds’ risk exposures could be a net positive relative to the core bond index.) We expect our absolute-return-oriented and flexible bond funds to underperform core bonds in a recessionary scenario. But they should still hold up much better than equities. So we’d view them as providing some protection and acting as at least “damp powder”—versus more “dry powder” cash or core bonds—that will be available to be reallocated to riskier assets (such as stocks) that will be offering more attractive return potential in the aftermath of a sharp market-pullback or a more sustained bear market.
Overall Portfolio Allocations
The table below shows our current Balanced portfolio target asset allocation versus its 60% stock/40% bond long-term strategic allocation.
To wrap up, let’s revisit a few investment principles that we believe are timeless, and are particularly important to keep in mind in the current environment.
1) Keep return expectations realistic. Our analysis suggests it is likely that returns for stocks over the next five years will be below their 10%–11% average return of the past 30 years, possibly far below. And it is as close to a dead-lock certainty as you can get in investing that this definitely will be the case for core bonds, given their very low current yield and compared to the incredible 8% annualized return they have generated since interest rates peaked in the early 1980s. With the S&P 500 up 6% per annum over the past five years and 4% over the past 15 years (and up 8% over the past 10 years), maybe most investors’ return expectations for stocks are properly calibrated. But then again maybe not, given the very strong returns for stocks since the market bottom in March 2009. In any case, it is more difficult to reach one’s financial goals in a low-return environment.
2) Focus on the longer-term fundamentals, not on highly variable short-term ups and downs of the markets. Things could get worse again before they get better. Even if they get better first, they will certainly get worse again. And then they will get better again. In other words, markets and economies move in cycles. In addition to focusing our analysis on longer-term factors that we feel we can more reliably evaluate, part of Litman Gregory’s investment discipline is to try to take advantage—through our tactical asset allocation process—of investor herding behavior and short-term overreactions to cyclical events or news headlines, whether positive or negative.
3) Investing should be viewed as a long-distance race where it doesn’t pay to over-emphasize any single short-term segment of the race. Expect periods where your portfolios are lagging a benchmark index and maintain your discipline during those times. They are inevitable. But a sound investment process requires discipline to work. Don’t be tempted to jump into “what’s working” in the markets simply because it has just had a 12-month or three- or five-year run of hot performance. For most people, that is a path to disappointment, whipsaw (buying high and selling low), and subpar long-term investment results. (Although a disciplined momentum-following strategy may work for some over the long term, which is not our approach.)
4) Cultivate self-awareness —a good thing to have—regarding your risk tolerance and psychology as an investor. This is another important element for achieving one’s long-term financial/investment goals. Are you in the right type of portfolio in terms of risk/return objectives for your temperament and your financial situation? Evaluate both your psychological ability to absorb downside risk and handle market volatility, as well as your financial ability to do so.
The research team at Litman Gregory will continue to work our hardest and smartest to make the best, informed investment decisions on your behalf, taking into account your long-term financial goals and ability to handle shorter-term risk. But we all share responsibility for reaching those goals. Keeping these principles in mind, and revisiting them from time to time, raises the odds that the benefits of a sound investment process and a long-term perspective will be fully realized.
—Litman Gregory Investment Team (4/1/13)
© Litman Gregory