Wednesday, December 26, 2012

Our view going forward...

I'm not one for making economic or financial-market predictions. There are far too many variables at play for any human being to even begin to accurately predict the future---even (if not especially) the economist with the most complex and tested models. And any investment advisor who would claim predictive talent is either profoundly foolish, or an outright charlatan. Personally, I'm more humble today than I was when I began my career 28 years ago. That said, I will herein make a few "assumptions" that I deem actionable for the disciplined long-term investor.

Note: The following references to sector and international equity allocations are directed only to that portion of your portfolio targeted to equities. For example; where I say 4% to 10% emerging markets, that would be 4% to 10% of just your equity exposure. I.e., if your target to stocks is 50% of your portfolio, your overall emerging markets exposure would be 2% to 5%.

Starting with the obvious:
Equity market volatility, as it always has, will present significant opportunity for investors who employ strategic asset allocation in the years ahead. That would be the simple process of targeting an asset mix between equity and fixed income assets and rebalancing to that mix at set intervals. For example; say global equity markets suffer 20% across the board declines over the next six months. The portfolio with a 60% target to equities would become substantially under-weight stocks. Thus, when it's time to rebalance, the investor will be selling fixed income securities and buying stocks sufficient to bring the portfolio's equities exposure back to the 60% target---in essence, buying while others are selling (when stock prices are low relative to the previous rebalancing date). If, on the other hand, stocks rally, the portfolio will become over-weighted equities. Thus, the investor would be selling stocks and buying fixed income securities sufficient to bring the portfolio's equities exposure back down to the 60% target---in essence, selling while others are buying (when stock prices are high relative to the previous rebalancing date).

As for sectors:
Consumer staples, healthcare and utilities should outperform cyclical/sensitive sectors---like technology, energy, industrials and financials---during extended periods of great uncertainty. Wise investors will maintain a reasonable allocation to these sectors at all times. Our typical client portfolio presently carries a 25% to 40% (of its equity exposure) allocation to staples and healthcare (heavier weighting to staples). We recommended an increase in staples late-summer 2011---prior to that recommendation our typical portfolio carried roughly a 20% weighting. Provided we gain a little clarity beyond the "fiscal cliff", we expect to recommend a lightening-up, back to 20%ish, in the coming year.

Industries whose prospects tend to rise and fall with the economy---technology, industrials, energy, financials, materials, etc.,---will likely, over the long-run, provide investor returns superior to the economically-defensive sectors, while experiencing larger price swings in both directions. In essence, the charts for the growth sectors, relative to consumer staples, etc., should show higher peaks and deeper valleys as the world economy meanders its way into the future. Our typical client portfolio currently weights cyclical/sensitive stocks 60% to 75% of its overall equity exposure. Provided we gain a little clarity beyond the "fiscal cliff", we expect to recommend a shift back to roughly 80% in these sectors during the coming year.

International:
We see unusual long-term opportunity in non-US economies, particularly emerging markets. During the first quarter of 2012 we recommended a modest move out of developed non-US markets to index funds that track the stocks of companies domiciled in China, Brazil, India, South Korea, Indonesia, Taiwan, Thailand, Malaysia and other emerging nations. The global economic concerns of the past few years have, we believe, offered up an opportunity to buy into those potentially robust economies at extremely attractive valuations. 85% of the world's population lives in emerging markets and, clearly, western ideals have taken root in the psyche of the citizens and leaders of many of these nations. That said, change can be painful, and we caution investors not to over-indulge in direct emerging markets exposure. Our typical client portfolio's equity exposure is weighted 4% to 10% directly to emerging markets.

We believe, geo-politics notwithstanding, long-term opportunities exist in developed-world equities as well. Particularly in companies with substantial reach into the emerging markets. The relatively young, forward-looking, populations in many of the developing economies (the average age of an Indian worker is 26)---with their need/thirst for infrastructure---presents opportunities for multinational companies in the U.S. and other developed nations. Think industrials, materials, technology, agriculture, energy and finance.

Economies are cyclical and, again, geo-politics notwithstanding, given where we've been over the past few years, a continued pick up in the global economy, however gradual---spurred by the allocation of presently idle capital and pent-up demand---is a distinct possibility in the intermediate-term. We do feel strongly however that the present ultra-easy monetary policy of much of the developed world will present longer-term challenges that may impact asset allocation decisions in the years to come. Inflation would be chief among those challenges.

Fixed Income Investing:
At the present pace of asset purchasing, the U.S. Fed's balance sheet will reach $4 trillion by the end of 2013. That's an expansion of $3.2 trillion over the past 4 years. Consequently, bank excess reserves are approaching a record $3 trillion (the Fed buys assets from banks). The net immediate effect of this activity has been to keep interest rates at utterly frightening lows. Frightening in the sense that when, if not before, the Fed can no longer credibly continue this policy, we should expect interest rates to rise. And with trillions in treasuries earning less than zero on a real (inflation-adjusted) basis, we could see the kind of domino exodus from bonds that would force rates substantially higher over a relatively short period of time. They will call it the bursting of the bond bubble. We are, therefore, recommending that investors approach the bond market with extreme caution. Our typical portfolio's fixed income allocation is presently heavily, if not entirely, in cash. Our best advice is to bite your lip and accept little or no real return, for now, on that portion of your portfolio meant to provide a buffer against volatility. A small consolation, for the yield-hungry investor, comes from the fact that many of the companies comprising, in particular, our clients' large cap value allocation have recently increased their dividend payouts---providing more of an income element, from equities, than had previously existed.

The Bottom Line - investment-wise:
The unpredictability of markets, while unnerving to some, forever offers opportunity for the disciplined investor. In fact, long-term investment success is indeed all about discipline. Investment mistakes are typically emotionally-driven. Fear can drive an investor out of equities long before his/her financial plan would have called for. Typically, and ironically, the times of extreme panic have tended to be extreme buying opportunities. Conversely, greed can inspire an investor to overweight---relative to his/her time horizon and tolerance for risk---a given sector, or stocks in general. Typically, and ironically, times of investor euphoria (think tech in the late 90s and real estate in the mid 00s) have tended to be ideal times to rebalance out of equities. 

Maintaining an asset allocation/rebalancing strategy keeps one from succumbing to the herd mentality. And, as we've discovered, following the herd is generally not your recipe for long-term success---think tech in the late 90s (irrational exuberance), the subsequent market bottom in March 2003 (extreme panic), and real estate in the mid 00s (irrational exuberance), and the subsequent market bottom of March 2009 (extreme panic). I suspect the holders of long-dated bonds have yet to learn that painful lesson.

The Bottom Line - economically, and societally, speaking:
While there's plenty in terms of geo-political risk to concern ourselves with at present, the future holds as much promise today as it has at any time in history. Yes, mistakes, particularly mistakes of policy, will be made. And yes, such mistakes will deliver hurdles and setbacks in the years to come. And yet future generations will witness the advancement of the human condition in ways we can't even begin to imagine. The ultimate pace of that advancement will be determined by the extent to which we possess the freedom to pursue our individual objectives, and the freedom to conduct business in the global marketplace going forward.

Near-term, I remain cautious. Long-term---bumpy roads notwithstanding---I remain wildly optimistic. That (long-term wild optimism) said, your portfolio must, at all times, reflect your time horizon and your temperament.

1 comment:

  1. [...] There’s no question that had today delivered a 300 point decline for the Dow, you’d have received one audio commentary, and at least one written, where I would have entirely dismissed today’s drubbing as a long-term non-event. Ah but what about today’s 300 point rally? Well, as much as I’d love to tell you that 2013 is off to the races, that today’s rally is indeed an event, and that you’d be wise to race on in with that hoard of cash you’ve stuffed under your mattress, I can’t. For if the dealmakers were, as the consensus suggested, destined to deal regardless—whether it be today or a month from today—a game-changer this ain’t. That said, while I can’t have you feeling good about the market because of yesterday’s deal, I can, however, have you liking the market for reasons I spelled out in Our View Going Forward. [...]

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