The quarter ended with a surprising turn as the Federal Reserve’s much-anticipated shift toward tapering its monthly bond buying failed to materialize at its September meeting. Shortly thereafter, monetary policy was upstaged by fiscal policy as Congress clashed over the budget and veered toward a government shutdown (which began just after the quarter ended). Despite these twists and turns, stocks posted another strong quarter. Large caps rose 5% and are now up 20% year to date. (See our benchmark returns table at right for complete performance details.) These gains have occurred even as the U.S. economic recovery remains only moderate and corporate earnings growth has slowed. Our portfolios are modestly underweight U.S. stocks based on our expectation of subpar returns in most scenarios. We address our bearish stock market views at length in the commentary that follows.
International markets improved in the third quarter following a rocky start to the year, particularly for emerging markets. Positives for developed markets included indicators of an improving economic outlook in both Europe and Japan. Among emerging markets, China showed signs of stronger growth (albeit at a lower rate than in prior years) so this was an overall positive given the country’s significance among emerging (and developed) market economies. Emerging markets as a group rose in the third quarter (despite losses for some countries) and developed international markets outperformed U.S. stocks. We have not made changes to our emerging-markets stock or bond allocations and review both in detail in the quarter’s update.
Finally, core bonds in aggregate were modestly positive for the quarter thanks in large part to a rebound in September as both the Fed’s decision to stand pat and investor risk-aversion in the face of an impending budget stalemate (and looming debt-ceiling standoff) were ultimately positive for bonds. The benchmark 10-Year Treasury yield ended the quarter at 2.64%, slightly higher than where it started, though down from its intraquarter high. Our underweight to core investment-grade bonds has benefited our portfolios considerably over this changing fixed-income environment as the more flexible bond funds we own instead have continued to outperform the benchmark.
For all the Fed’s good intentions about being transparent, it is ironic that it has managed to surprise market participants yet again. A mere mention of the possibility of tapering its bond purchases (i.e., quantitative easing) this summer led to a spike in bond yields not seen for nearly 20 years. More recently, when most investors expected the Fed to start tapering, the Fed decided to delay, bringing bond yields down sharply following the September 18, 2013, announcement. While we do not focus on such short-term market moves (or devote time trying to second-guess monetary-policy decisions), both the Fed’s actions and the market’s subsequent reactions raise several questions in our minds, which only serve to reinforce our view that an unusually broad range of outcomes remain very possible.
While the Fed can try to manage market expectations, it obviously does not control them. The bond market appears to have overreacted on tapering news this summer. Fed Chairman Ben Bernanke cited the sharp increase in long-term bond yields as one of the reasons behind the Fed’s decision to delay tapering. In other words, bond yields went up more than the Fed expected or wanted. How can we be confident the Fed will be in control when it unwinds its massive balance sheet? How can we be sure that, down the road, this experimental monetary policy will not lead to high inflation?
Maybe the bond market did overreact, but how egregious could its overreaction be? After all, we are still well below normal interest-rate levels. What does it imply about the health of our economy if the Fed appears concerned that it cannot absorb interest rates that are slightly higher than it expected? It might suggest that our economy still faces significant deflationary pressures. If not, surely the Fed has risked its credibility for little gain since the amount of tapering in question was too small to matter relative to the size of our economy. If the Fed’s credibility comes into question, how will it smoothly exit the ultraloose monetary policy we have today?
One beneficiary of the Fed’s ultra-loose monetary policy has been housing. The rise in housing prices over the past nine to 12 months should go at least some way in fixing household balance sheets, lowering their need to deleverage. According to CoreLogic, an analytical services firm, about 15% of U.S. households have mortgages that are under water, i.e., their house is worth less than their mortgage, which is typically their biggest liability. This is a significant improvement from the 26% reported back in late 2009 and 22% about a year ago.
While housing is a positive development, the rapid rise in home prices is concerning and we question its sustainability. Another question is how housing prices will react to the recent sharp increase in mortgage rates, and to future increases in those rates as the Fed eventually normalizes its interest-rate policy. We plan to assess how the recent increase in housing prices impacts the progression of our deleveraging thesis. It is important to remember that the absolute level of debt within the economy has not declined in a material way. Some of it has merely shifted from the private sector to the public sector. Ultimately, this debt has to be paid back, i.e., public-sector deleveraging will have to take place at some point since the current path is mathematically unsustainable.
How We View Our Fiduciary Role When Managing Client Portfolios in This Uncertain Environment
The word “fiduciary” is defined as “relating to, or involving one that holds something in trust for another.” Another word that goes hand in hand with being a fiduciary for our clients is “prudence,” which is defined as “careful management.” In our industry, these words—fiduciary and prudence—are used liberally. We want to share what these words mean to us and how they influence our day-to-day management of client portfolios.
Our typical client in a balanced portfolio expects us to maximize long-term return without losing more than 10% in any normal 12-month period. There’s an inherent trade-off in this dual objective. Managing to a downside risk threshold sometimes means we have to be willing to leave some return on the table. We have always said we do not manage our portfolios to one economic or asset-class scenario because we don’t think we can know with confidence which scenario will play out. We hope optimistic scenarios play out, but do not build portfolios based on them unless we believe they are likely. Investing based on hope would not be in line with acting as a responsible fiduciary for our clients who have specifically entrusted us with the mandate to care about downside risk.
Managing portfolios to withstand various scenarios is as much art as science. In shielding our clients from one scenario, we expose them to others. The key is to strike a reasonable portfolio balance that allows us to meet our clients’ risk and return objectives over the long term. As we noted above, both inflation and deflation risks exist, and both are bad for risk assets. Our economy is still fighting significant deflationary headwinds due to ongoing private- and public-sector deleveraging. At the same time, the experimental monetary policy of keeping short-term interest rates near zero over extended periods could easily stoke inflation, and we don’t know if and when that would occur. In this inflationary scenario our clients would expect us to protect their purchasing power. It would be nice if we had a crystal ball to know which outcome will occur and when, so we can position our clients’ portfolios accordingly. But part of being intellectually honest is acknowledging that we do not have a crystal ball and there are many unknowns, especially now, when we are going through a major deleveraging episode and the range of possible outcomes is unusually wide. Our job becomes harder in a period when most assets appear to be richly valued. So, how do we balance out two extreme risks—inflation and deflation—given each scenario warrants a vastly different portfolio positioning?
To protect our balanced portfolios from a recession or deflation outcome, we continue to have a decent allocation in investment-grade or core bonds. In such an environment, interest rates would likely fall, and core bonds would increase in value as most risky assets are declining. We cannot ignore this outcome because in this scenario our stated 12-month risk-threshold objective is most at risk. Given their very low yield levels, core bonds would not give as much protection as they did in the past, but would still do a much better job of protecting capital than most other asset classes in this scenario.
That said, we acknowledge that relative to history, core bonds carry a significant opportunity cost. Our expected returns from bonds are extremely low across all of our five-year scenarios; if we were to carry a full allocation, there is the significant risk that we could fail to meet our clients’ return objectives. As a result, roughly half of our bond allocation has gone to absolute-return-oriented and flexible, or non-core, bond funds. Over 12 months, in a recession/deflation scenario, absolute-return-oriented and non-core bond funds are likely to lag core bond funds that have a longer duration and heavier emphasis on Treasury bonds. But over our five-year investment horizon, absolute-return-oriented and non-core bond funds are likely to generate significantly better returns. The value of these bond funds comes from their underlying managers’ ability to add value by investing opportunistically across fixed-income sectors (without being constrained by the core benchmark) as well as from individual issue selection.
Some of our U.S. equity underweight has also gone to fund a few of the absolute-return-oriented and non-core bond fund investments, and here we see the latter’s role differently. Over a 12-month period, we expect our absolute-return-oriented and non-core bond fund investments to have much less downside risk than stocks, and similar or better returns in all but our most optimistic five-year scenarios. That is not such a bad trade-off in and of itself. In the past several years, these funds have generally met our expectations. Through a strong period for stocks, they have provided a reasonable return with much less risk. In addition, by having a lower allocation to stocks, we worry a bit less about capital preservation in a deflation/recession scenario and can afford to have less protection in the form of core bonds, which, in addition to having poor return prospects over our five-year investment horizon, expose us to the risk of rising interest rates. Again, our goal is to factor in multiple scenarios and strike an appropriate balance when constructing portfolios. If we were to worry only about recession/deflation risk and have more in core bonds, we may end up overexposing the portfolio to rising interest rates, which could result from an improving economy, inflation, and/or investors’ concerns about the country’s large debt and deficits.
Building a sensible portfolio in an uncertain environment is not just about having different pieces in place to ensure the portfolio can withstand different scenarios and outcomes. It is also about understanding the risk and reward of each asset, the role of each asset in the portfolio, and how assets interact with each other. This understanding helps us optimally position portfolios in our clients’ favor, and offset, at least to some degree, the cost their portfolios bear to insure against the unknown (which, without that crystal ball, is an unavoidable cost).
To cite some examples, we have underweighted U.S. stocks for much of the period since the 2008–2009 recession. In the early part of the recovery, we found high-yield bonds offered us a better return at a lower risk level than U.S. stocks, so we chose to overweight the former (by a lot) at the expense of the latter. We also had a successful, albeit short, tactical overweight to emerging-markets stocks, also funded largely from U.S. stocks. Later, we chose to fund a good part of our large allocation to emerging-markets local-currency sovereign bonds from U.S. stocks. This position reduced the opportunity cost of underweighting stocks during this period, and with much lower risk. In addition, it served as a cheap, longer-term insurance hedge against the risk of a decline in the U.S. dollar, and the related inflation risk. It worked well enough such that in 2011 and 2012, we sold a good chunk of emerging-markets local-currency bonds to fund other assets (the sale reflected the bonds’ lower return potential as well as broader portfolio-risk considerations), and we held on to some emerging-markets local-currency bonds because we view them as more of a strategic long-term position (we discuss why below). Last year, U.S. stocks clearly trounced the other assets we held in its place, but even then our overall performance was solid as other areas of our portfolio (such as our actively managed bond funds) performed well. As such, despite being underweighted to the best-performing asset class (U.S. stocks), our balanced portfolios have outperformed their benchmarks over the past five years.
Rational Reasons for a Bearish View on U.S. Stocks
We are maintaining our underweight to U.S. stocks in our balanced portfolios. (The underweight ranges from 9% to 11% depending on the portfolio.) Over the past two years or so, GAAP trailing 12-month earnings have gone nowhere, but the market has continued its ascent, especially over the past year (Chart 1). The S&P 500 now trades at 19x trailing 12-month earnings. In our base-case scenario, we assume a 15x multiple on our normalized earnings number five years out. This is an average historical multiple excluding the market’s frothiest periods and a prudent multiple in our view given the deleveraging headwinds are still in place. If the S&P 500 were to trade at 15x current trailing 12-month earnings, it would imply a price of around 1,350 on the S&P 500 index, i.e., a decline of roughly 20% from present price levels. This would bring U.S. stocks within our fair-value range and roughly the level where we’d consider raising our exposure to U.S. stocks to our strategic level.
On the other hand, given that most investors expect the Fed to keep short-term rates near zero until 2015 at least, P/E multiples of 18x–20x are quite conceivable in this environment, and quite normal to most investors who in their professional lives have only experienced the post-1980s investing world. Applying those P/E multiples to our normalized earnings five years out, then adding a dividend yield of slightly over 2%, we get returns in the 6%–8% range—not bad at all considering that the expected returns of other asset classes we can invest in are generally lower. This is one reason we are not more underweighted to U.S. stocks. On the other hand, if stocks continue to rise to the point where U.S. stocks start looking unattractive, even given these optimistic valuation multiples, we will lighten-up further.
While our normalized earnings and P/E framework remains our primary valuation tool, we consider other approaches, frameworks, and viewpoints, and ultimately make decisions based on what the weight of the evidence tells us. In the article below, “Sales and Margin Analysis of U.S. Stocks,” we discuss another framework for analyzing U.S. stocks based on a sales-margin analysis. This analysis also suggests we should remain underweighted to U.S. stocks. The key point to take away from this analysis is that in order to get any return from U.S. stocks we have to use aggressive or optimistic sales-growth and margin assumptions relative to history and what we’d consider prudent. We can’t justify margins staying at these elevated levels over our investment horizon, so it means we need to remain patient before we are proven right.
The Investment Letter is mailed quarterly to our clients and friends to share some of our views. Certain material in this work is proprietary to and copyrighted by Litman/Gregory Analytics and is used by Capital Trust & Associates, LLC with permission. Reproduction or distribution of this material is prohibited and all rights are reserved.
Sam Alaoui and your Capital Trust & Associates, LLC Research Team.