Following their very strong gains in 2013, U.S. stocks fell sharply in January and other risk assets declined as well. Large caps were down 3.5% and small caps lost 2.8%. Investors digested a variety of indicators over the course of the month, including signs of a slowing housing sector, some disappointments among corporate earnings releases, and, more broadly, ongoing fears of slowing growth and a worsening of downward currency pressure in emerging markets.
Toward the end of January, the Federal Reserve Open Market Committee announced its second reduction in monthly bond buying. The accompanying statement—the last one released under Chairman Ben Bernanke (whose term ended January 31)—indicated the Fed continues to see a pickup in economic activity and that the outlook “on balance” showed improvement. At the same time, the Fed also reiterated that its future decisions are not a foregone conclusion but rather are data dependent, based on its assessment of inflation risk and the health of the labor market (among other factors). In another highly watched announcement, fourth quarter 2013 GDP was released toward month end and presented one of January’s more positive data points. The 3.2% growth rate was generally in line with market expectations and, in combination with third quarter GDP marked the strongest six-month growth rate for the U.S. economy in recent years.
The emerging-markets selloff continued in January (after a rough 2013) amidst evidence of slower growth in China as well as ongoing concerns about potential spillover effects from country-specific currency declines. In an effort to manage inflation risk (and help slow capital outflows), the central banks of some particularly hard-hit currencies—such as Turkey, India, and South Africa—raised rates during the month. Among developed markets, Japan had a very sharp selloff after its robust 2013 gains while Europe generally posted losses in line with the United States. Uncertainty hangs over both areas as Japan undertakes significant effort to boost growth and generate a healthy level of inflation, and Europe seeks to manage deflation potential and financial-sector risk while negotiating a weak recovery.
As we would expect from a month when risk assets fell, bonds offered some offset. The core bond benchmark rose 1.5% and the 10-year Treasury bond yield declined to 2.7% at month end (from around 3% at the start of the year). Our actively managed core bond funds outperformed in aggregate and our portfolios also benefited from their allocation to lower-risk alternative strategies and overall underweight to equities. As could be expected, bond funds that take on credit risk lagged higher-credit-quality funds, though they too were positive in January.
Recent market events have not resulted in any positioning shifts in our portfolios; however, as we discuss in the commentary that follows, we are currently evaluating our equity scenarios and are closely monitoring risks in emerging markets (and elsewhere). Moreover, we have intensified due diligence on a few of our fund holdings following manager changes. Should our conclusions prompt the need to do so, we will adjust our portfolios accordingly.
We regularly use a question-and-answer format to address questions from readers about our investment views and current strategy. This format permits us to address a range of different topics and allows readers to focus on areas of interest. Members of our research team worked on this Q&A piece jointly, and answered questions received during the past several weeks.
Following the financial crisis, there were significant macro risks and uncertainties that were influencing your investment outlook and portfolio positioning. Many of these risks ultimately haven’t played out and as a result, your conservative positioning has led to a drag on performance. Given what could be considered many bullish indicators for risk assets (improving macro fundamentals, low inflation, accommodative monetary policy, progress on deleveraging, domestic energy production, etc.), can you talk about what might cause your outlook to improve?
As we wrote in our Year-End Investment Commentary, our macro outlook has improved as economic fundamentals have become more positive over the past year and the more severe tail risks, including a potential debt-deleveraging downward spiral that we were particularly concerned about in the aftermath of the financial crisis, did not play out. As a result, we are actively reassessing our base-case deleveraging thesis and the key assumptions that underlie our expected return estimates for U.S. stocks across our four broad macro scenarios.
In terms of reassessing our U.S. stock exposure, one key assumption we are evaluating is the 15x valuation multiple that we apply to S&P 500 GAAP earnings (not operating earnings) in our base-case scenario. Thus far we have been too conservative on the valuation multiple, with the market now trading at around 19x trailing 12-month earnings. The P/E multiple has expanded sharply over the past two years (e.g., it was 14.5x at the end of 2011), which leads us to conclude that at least some (if not most) of the improvement in the economy we have been seeing is already reflected in stock prices. It is also worth noting that if the S&P 500 were currently trading at a 15x multiple, i.e., at around the 1,400 level, it would fall within our fair-value range, albeit at the upper end of the range, and we’d very likely have a higher allocation to U.S. stocks. So our potential return calculations are quite sensitive to the valuation multiple assumption and our analysis considers a range of possible multiples within each macro scenario.
One scenario in which U.S. equities could become more attractive is if there was a market sell-off and prices fell low enough to warrant taking on more risk. Absent a correction in risk assets, when might you consider adding more equity exposure to your model portfolios?
Absent a significant market correction from present levels, if after our reassessment we conclude that the majority of the private-sector deleveraging headwinds are behind us, instead of using the post-Depression era as our primary frame of reference for earnings growth and valuations (a very slow and uneven recovery from a banking crisis and deep economic downturn), we may place greater weighting on the post-1980s environment and, as a result, adjust our assumptions to reflect a post-1980s valuation framework. This would likely mean using higher P/E multiples than the 15x we use in our base case, which all else being equal would make U.S. stocks more attractive. Our optimistic scenarios, where we currently estimate double-digit returns for U.S. equities five years out, might also have a higher likelihood of playing out. This change to how we weigh our various economic scenarios could also lead us to add to equities. Of course, before adding to equities we will carefully assess whether or not they are overvalued and pose significant downside risks in the context of an improving macro environment but one that we still view as highly uncertain and containing unique risks (such as the unintended consequences of unconventional monetary policy, deleveraging in the eurozone financial system, and China’s transition to a more consumer-driven economy).
Will you briefly reflect on your overall equity positioning with the benefit of hindsight?
To step back and take a broader perspective regarding our equity underweight, given our absolute-return orientation and our mandate to manage to a specific 12-month downside-risk threshold for each type of portfolio, we felt it prudent to manage to the risk scenario of a disruptive and/or lengthy deleveraging process. So for the most part, our equity underweight was a risk-based (or defensive) tactical allocation rather than a return-based fat pitch. In other words, our underweight to U.S. stocks was not driven as much by our expectation of superior returns in other asset classes, as by our assessment that the downside risks for equities were significant across a range of scenarios, and U.S. stocks’ return potential was not high enough to adequately compensate us for those risks.
The fact that the risk scenarios we were defending against with our equity underweight did not play out has certainly been a drag on our recent relative performance (though we are pleased with the absolute returns we have been able to achieve for our clients). That said, we’ve had a decent allocation to equities all along, so our clients have participated in the current bull market—and in most cases, our portfolios have outperformed their benchmarks over the trailing five years during this bull market period.
assessing emerging-markets risk & return
The addition of emerging-markets stocks and bonds was a drag on portfolio performance in 2013. You’ve funded your emerging-markets local-currency bond position from equities and while the risk side of that decision makes sense, does Litman Gregory continue to think the return potential is comparable?
Speaking to emerging-markets local-currency bonds, we’d agree that there are short-term risks stemming from a few countries. But as we discussed in our third-quarter commentary, we think contagion risk, where even emerging-market countries with decent fundamentals suffer significant currency declines, is low. However, we have also acknowledged this risk is not zero, and we’d agree with other strategists who suggest emerging-markets local-currency sovereign bonds are unlikely to generate the kind of returns they did when they were a relatively undiscovered asset class. We expect mid- to upper-single-digit returns over the long term from emerging-markets local-currency bonds in our base-case scenario. This is much lower than the low-double-digit returns, annualized, they have delivered over the past 10 years ending December 2012.
We have been investing in emerging-markets local-currency bonds since 2005, and they have performed well for us, until last year. In fact, we had a much higher allocation to them until 2011, when we reduced them by about half, due in part to valuations, and locked in some gains. We also completely sold the position out of our equity models at that time. But, we kept a relatively small position (3%–5%) as a strategic-like weighting in our balanced models to manage the risk of a dollar decline, and that hurt us last year.
The potential returns from emerging-markets local-currency bonds compare favorably to our base-case deleveraging scenario for U.S. equities, where we use a discounted P/E multiple of 15x. But if we were to apply a higher, post-1980s kind of a P/E multiple, or give our optimistic scenario larger weighting, then the case for funding emerging-markets local-currency bonds from equities becomes weaker, though it does not negate it either. They still serve as a potential hedge or insurance against the risk of a dollar decline and the resulting U.S. inflation. Insuring against this risk remains prudent in our view, given the Fed’s unprecedented monetary policies in recent years. And as we have written in the past, our time horizon for emerging-markets local-currency bonds is longer than the five years typical for our tactical positions, which is why we referred to it earlier as strategic-like.
There is a caveat though. Despite the long-term benefit we see in emerging-markets local-currency bonds, they may become a source of funds if and when we reduce our underweighting to equity risk. As mentioned earlier, we manage our portfolios to specific 12-month risk thresholds in addition to maximizing returns. Given emerging-markets local-currency bonds’ equity-like downside, we may decide to lower our exposure to them in order to not increase the risk of breaking our stated risk threshold targets. We will admit that our worst fears were realized last year and emerging-markets local-currency bonds have ended up being an expensive form of insurance against the risk of a dollar decline, at least in the short term. So in the coming months, along with assessing our broad economic and equity scenarios, we will continue to weigh the cost and benefits of emerging-markets local-currency bonds, keeping in mind the overall portfolio risk and return objectives (we have to be careful to not place too much emphasis on individual pieces and lose sight of the broader portfolio goals).
We appreciate your confidence and trust.
-Your Capital Trust & Associates, LLC Research Team
As always, please feel free to call Sam or email with questions and comments to email@example.com
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