Thursday, December 19, 2013

Our View Going Forward, December 2013...

I began last year's year-end letter with the following: 
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.

The only thing I would change in this year's intro would be to replace 28 with 29. In fact, there's virtually nothing else in last year's entire letter that I would alter. Which makes sense given that the message offered nothing by way of near-term predictions (I did suggest there'd be some sector rotation in 2013, which there was). My aim was, and remains, to offer a long-term macro view of the investment world.

Here's our present (12/2013) view on asset classes and sectors:

First and foremost, we believe that patient, long-term-minded investors should maintain a target mix between equities (stocks, real estate, commodities) and fixed income assets (bonds, cds, cash, etc.). Individuals with high risk tolerance would maintain greater exposure to equities than those who view themselves as moderate or conservative.

I'll begin with a no-brainer, fixed income: We believe strongly that interest rate risk remains very much to the upside. Therefore, assuming we're right, investors should shun all but very short maturity bonds (bond prices fall when interest rates rise, and the longer the maturity the harder the fall). I personally prefer cash and short-term CDs for the time being. There appears, however, to be a fair number of other advisers who are attempting to bring yield to their clients' portfolios by replacing standard, high quality, fixed-income securities with real estate investment trusts, high dividend paying stocks, junk bonds, muni bonds and emerging market bonds. As I stated in A 0% Return Can Be A Beautiful Thing, I completely disagree. In my opinion, the primary objective of the fixed income component of your portfolio should be preservation of principal. High volatility is to be had, and exploited, on only the equities side of your allocation. 

Speaking of equities: As you've noticed---with just a few trading days remaining---2013 has been a very good year for the U.S. stock market. The following returns (of widely used ETFs) are as of 12/18/2013: Broken down by sector, consumer discretionary (+40%), health care (+39%), industrials (+37%) and financials (+33%) have led the way year-to-date. The laggards have been commodities (futures) (-8%), real estate investment trusts (+2%), utilities (+12%), materials (+22%), energy (+23%), consumer staples (+25%) and technology (+27%).*

In terms of market cap and style (excluding mid cap, and blending growth and value for small cap): Small Cap has led the way (+33%), followed by Large Cap Value (+29%) and Large Cap Growth (+28%).*

In terms of global comparisons: The S&P 500 Index (+29%) has handily outperformed the non-U.S. developed market EAFE (Europe, Australia and Far East) Index (+18%) and the FTSE Emerging Mkts Index (-5%).*

*Source of returns data: Morningstar®.

In a recent blog post I offered up my view of sectors from both valuation and cyclical standpoints. I'll expand a bit here by including mutual fund/etf styles, as well as hone in on the division among what we consider to be today's most attractive sectors. Consider this a baseline recommendation. Actual allocations are determined on a client by client basis. 

Equity Mutual Fund/ETF style allocation (as a percent of a portfolio's equity exposure):

U.S. Large Cap Value: 32%
U.S. Large Cap Growth: 31%
U.S. Small Cap: 05%
Developed International: 25%
Emerging Markets: 07%

The above allocation reflects an increase in developed international and emerging markets exposure, a 50% decrease in small cap and slight decreases in the remaining two categories when compared to our year ago targets.

Sectors with 10%+ recommended weightings:

Technology 15-20%
Financials 10-15%
Materials 10-15%
Industrials 10%
Energy 10%
Staples 10%

Now, as scientific as you might imagine our selection process to be, there's no assurance that the above allocation will deliver improved results at the margin (which is what we're after). I can easily articulate a scenario for every one of the above sector picks that would logically counter whatever I believe justifies its 10+% weighting. And that's essential to the process: For me to take, for example, a given client's exposure to materials stocks from, say, 4% to 10%, there has to be investors (holders of materials stocks) out there who think that's a bad idea---who are looking to unload their positions onto fools like me. Without opposing views (buyers and sellers) there'd be no market. You can, therefore, see why diversification is so important.

Beyond asset class and sector selection, there's the real important stuff---the stuff that goes on between the ears: Like maintaining a proper perspective on volatility and asset allocation. Like understanding the opportunities that lie beyond our borders. Like understanding the cyclical nature of the economy and the influence of monetary policy on the cycle and on the pricing of fixed-income securities. Like never making emotionally-based investment decisions. And like understanding that, politics notwithstanding, our future is as bright today as it's ever been. All points I made in last year's letter, and feature once again below. Please read the following in its entirety:

Equity market volatility, as it always has, will present significant opportunities 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, all else being equal, with a 60% target to equities would become substantially under-weight. Thus, when it’s time to rebalance, the investor will be selling fixed income securities and buying equities in a quantity sufficient to bring the portfolio’s exposure back to the 60% target—in essence, buying while others are selling (when equities prices are low relative to the previous rebalancing date). If, on the other hand, equities rally, the portfolio will become over-weight. In which case the investor would be selling equities and buying fixed income securities in a quantity sufficient to bring the portfolio’s exposure back down to the 60% target—in essence, selling while others are buying (when equities prices are high relative to the previous rebalancing date).

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.

(Note: The opportunity for growth I continue to see in emerging market equities was not nearly realized (in fact share prices declined) in 2013. Here's a recent blog post where I explain how quantitative easing in the U.S. has led to extreme volatility in the emerging markets.)

We believe, geo-politics notwithstanding, that 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 emerging 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 (it's now there). 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 close to (or 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 would 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 equities 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. […] As you’ve noticed  (here, here and here), the Eurozone has been on my radar of late. Other than a passing remark regarding the Bank of China’s easing stance, I haven’t said much about the emerging markets the past few weeks. Of course you clients know, given the emerging markets speech you suffer through at virtually every review meeting, that I remain a huge long-term bull. I mean, emerging markets (think China, India, South Korea, Indonesia, South Africa, Brazil, Mexico and the like) are where 85% of the world’s humans live. They’re where young materially (as in materialism)-thirsty workers reside. They’re where populations are growing (critical to a growing economy). They’re where infrastructure has huge catching up to do. In short, they’re where the world’s greatest opportunities lie. They’re also where volatility is defined. Therefore, we can’t go hog-wild into the emerging markets. We can, however, as we have in many portfolios (of willing clients) add incrementally over time. Here’s what I wrote in last December’s “Our View Going Forward”: […]