January 20, 2009
Asset Allocation
We believe a conservative allocation is essential for 2009, as dictated by deteriorating worldwide economic conditions and negative investor psychology. While record amounts of cash are in money market accounts, investors must overcome the psychological hurdle of a decade of near-zero returns in the US equity markets before reinvesting these funds. As Woody Brock has said, “Investors are rightly disenchanted with the fact that stocks have lost them money over the past decade. There is nothing like growing disenchantment with past returns to drive valuations lower.”
We recommend four asset classes:
- Treasury Inflation Protected Securities (TIPS)
- Mortgage Backed Securities
- Investment Grade Corporate Bonds
- Actively managed US equities with a value-oriented approach
Yields on TIPS now reflect a break-even rate on inflation of less than 50 basis points over the next 10 years. Inflation must average less than .5% over this ten year period for TIPS to be inferior to fixed-rate Treasuries, a highly unlikely scenario. Although deflation may persist in the short term, huge government deficits will surely lead to inflation. TIPS offer excellent returns in an inflationary environment, and they offer a reasonable hedge against John Williams’ forecast of hyperinflation (although, if you fully accept Williams’ forecast, the only safe asset is gold).
Mortgage-backed securities, backed by the US government, offer yields of 4%-6%. The challenge in this market is that the government is buying some of these securities, driving up prices. The best approach to this market is through a mutual fund or other professionally managed account.
Our case for investment grade bonds was stated in our November 18 article noted above, and that case was echoed by Loomis Sayles’ bond manager Dan Fuss in the December 2, 2008 article, The 50-Year Opportunity in Bonds.
Vanguard founder John Bogle, in our interview on December 23, 2008, said “I expect equity investors will realize 8-10% returns over the next decade.” Returns approaching these levels are still available in the investment grade bond markets with 10-year maturities, reinforcing our belief that broad-based equity exposure is unjustified in the current markets.
We believe the upheaval and forced selling in the US equities markets creates the exact environment where talented value-oriented managers will thrive. We interviewed one such manager (Bruce Berkowitz on January 6, 2009) who said that the opportunities for the types of companies he likes to buy were better than at any time since 1974. Such exposure to US equity markets may take more than one year to pay off, but it offers a good hedge against the possibility that we are wrong in calling US equity markets still overvalued.
For taxable accounts, attractive values remain in the municipal markets. But many state and local governments are under significant financial stress, and careful credit analysis is essential in these markets. We would avoid all high-yield municipals (as we would avoid high-yield corporate bonds).
The worldwide recession means non-US equity markets are unlikely to offer significantly more attractive returns over the next year, and will likely exhibit more volatility. Our conservative bias for 2009 argues for equity positions concentrated in the US markets.
We believe private equity and venture capital returns will be depressed in coming years. Private equity will suffer because of its reliance on leverage, and venture capital will suffer because smaller companies will find few opportunities for growth in a risk-averse environment.
REIT returns will suffer as conditions in the commercial real estate market deteriorate and funds experience difficulty rolling over debt financing.
Oil is undervalued. Once the economy returns to full capacity – which may take several years – oil will return to levels approaching its previous highs ($140/barrel). We believe oil prices are governed by supply and demand (see our article Oil Prices in the Era of Thugocracy) and not by speculator manipulation. Our view is predicated on a belief in the theory of peak oil; those not ascribing to this belief will have a different forecast for oil prices.
Display article as PDF for printing.
Would you like to send this article to a friend?
Remember, if you have a question or comment, send it to .
