UPDATE: The Rest of the Year

by Matt Malick and Ben Atwater

Many clients have been wondering how we see the balance of the year for financial markets.

First, it is important to understand that 2013 has been a tale of two markets – U.S. stocks and everything else.  In contrast to the strength of U.S. equities, nearly every other market, from gold to emerging markets to alternative investments, has seen results ranging from terrible to lackluster.

In 2013, the broadly diversified, or endowment, model of investing dramatically underperformed U.S. markets.  Although we consider ourselves diversified investors, we have been positioned much more in line with what has worked – U.S. stocks.  Therefore, our clients have been particularly successful so far this year.

Although there are no guarantees, the period from Thanksgiving through Christmas has historically been solid for U.S. stocks.  Since 1945, the S&P 500 has averaged a gain of 1.76% with positive returns 71% of the time, according to Bespoke Investment Group.  And, in years where the market is already up 10% leading into Thanksgiving, average returns are a slightly more robust 1.89%.

Bespoke further calculates that in the current bull market, which began in March 2009, the S&P 500 has averaged a gain of 4.41% from the end of Thanksgiving week through year end, with positive returns every year.

The most commonly cited risk to the market right now is the idea that the Federal Reserve could “taper” its quantitative easing program (the purchase of $85 billion per month of Treasury Bonds and mortgage-backed securities in the open market).  Each time the market perceives tapering as a possibility, stocks slide.  We most certainly agree that this is a risk for the market, but we believe tapering is still many months away.

Another potential pitfall for the market is valuation.  Stocks are no longer cheap.  At best, by historical standards, they are now fairly priced at about 16.5 times trailing earnings.  However, in an extended bull market, equities tend to get awfully expensive before valuations correct.  In other words, the stock market usually goes down too much and then up too much.  Unlike Goldilocks, Mr. Market likes it too hot and too cold.

For now, we believe our focus should be twofold:  1) continuing to rebalance accounts to long-term asset allocation targets, which has meant trimming stocks and patiently adding to bonds and 2) looking for stocks that are less expensive than the market, which potentially adds a margin of safety if we encounter a market correction.

Faux-Sophistication

By Matt Malick and Ben Atwater



“That’s been one of my mantras - focus and simplicity. Simple can be harder than complex:  You have to work hard to get your thinking clean to make it simple. But it’s worth it in the end because once you get there, you can move mountains.” - Steve Jobs, 1998 Business Week Interview

We have written extensively over the last five years about the effectiveness of a simple, understandable, transparent and low-cost investment philosophy.  The way we invest, which we outlined for the first time in September 2008, stems from the discomfort we experienced while watching our industry slip into darkness.  Luckily, our timing could not have been better.

For the five years ending September 30, 2013, the most basic index of American stocks, the Standard and Poor’s 500, doubled the annualized performance of the Hedge Fund Research Incorporated Fund Weighted Composite Index - 10.02% versus 5.01%.  This means that a passive basket of U.S. stocks dramatically outperformed the sophisticated, “go anywhere” strategies that the most brilliant practitioners on Wall Street conceived.

Lately we have fielded several inquiries about alternative investment strategies as a way to manage risk.  It seems to us that despite all the evidence to the contrary, investors are still searching for something that doesn’t exist – a formula to sidestep market losses while also getting a better return than bonds currently offer.

And this impossible quest is not limited to individual investors. The New York Times recently reported that “so-called alternative investments now account for almost one-quarter of the roughly $2.6 trillion in public pension assets under management nationwide, up from 10 percent in 2006, according to Cliffwater, an adviser to institutional investors.”

The Rhode Island pension plan, for example, has increased its investments in alternatives from zero to almost $2 billion, or 25% of its assets, in the last two years.  The result has been poor performance and outrageous fees.  Their investment expenses for the year ended June 30^th were $70 million versus a prior estimate of $11.5 million, primary due to alternative investments that charge up to 2.5% annually of assets under management plus another 20% of profits.

In reference to individual stock investing, the legendary Fidelity Magellan Fund manager, Peter Lynch, said, “The simpler it is, the better I like it.”  We think this sentiment applies to investing in general.  You can observe a great example of this in 2008, a terrible year for the stock market, and the ensuing market recovery in 2009.

In 2008, the S&P 500 fell a whopping 37%.  But, interestingly, the Barclays U.S. Aggregate Bond Index actually rose 5.24% that year.  So, if you had a 50% stock and 50% bond portfolio, you would have lost 15.88%.  Not good, but far from devastating.

Then in 2009, the S&P 500 rose 26.46% and the Barclays U.S. Aggregate Bond Index rose 5.93%.  The same 50 / 50 portfolio would have gained 16.20%.  If the portfolio was rebalanced annually, then less than a year removed from the financial crisis and Great Recession, an investor in a plain vanilla balanced portfolio would have almost fully recouped all losses.

Lastly, in 2010, the same 50 / 50 portfolio would have generated 10.8% returns, putting the portfolio back in the black and well-positioned for robust returns in the years since.  (Even without annual rebalancing, a 50 / 50 portfolio would have produced positive three-year returns from 2008 through 2010.)

As evidenced above, risk mitigation techniques do not need to be fancy, overly complex or expensive.  Frankly, in our experience, the more esoteric these schemes, the less effective they are.  Make no mistake, finding the proper allocation to high-quality bonds to complement your stock exposure is the best risk management strategy – it is straightforward, transparent and low-cost.

The chart below shows that even during a protracted bear market for bonds (1941-1981) - a time when interest rates rose and bonds prices fell – they still proved an excellent risk manager.  The standard deviation (a statistical measure of variation around the mean) for a 50% stock / 50% bond portfolio was half that of an all-stock portfolio, or half the risk.
 
 
 

Ignoring the advice of Leonardo de Vinci that “Simplicity is the ultimate sophistication,” many risk-averse investors will buy anything, as long as it sounds sophisticated, regardless of whether they understand it.  Or maybe the fact that they don’t understand it gives a certain level of comfort – if it’s that complicated, it must be good!

The old economic axiom, “There’s no such thing as a free lunch,” provides a cautionary message to people looking to manage risk via magic trick.  Investors are naïve to believe strategies actually exist that can consistently shuffle money from one asset class to another with precision, or predict which stocks will spike over the short-term even when the market declines, or that can use options to truly protect against the downside without considerable cost, etc.

The martial artist and movie star Bruce Lee believed that, “It is not a daily increase, but a daily decrease.  Hack away at the inessentials.”  From an investment standpoint, be honest with yourself about what you are trying to accomplish.  Don’t subscribe to the myth that a black box exists that will protect you from high stock prices and low bond yields.  Instead, avoid the temptation to purchase investments that are supposedly sophisticated enough to outperform the tried and true.

A final thought from Peter Lynch: “All the math you need in the stock market you get in the fourth grade.”  This may sound unreasonable, but it’s surely true.  A real investment discipline will outperform all of the gimmicks.

UPDATE: Washington Woes

  by Matt Malick and Ben Atwater

“Politics is the art of looking for trouble, finding it whether it exists or not, diagnosing it incorrectly, and applying the wrong remedy.” - Ernest Benn
 
“Politicians are like diapers.  They both need changing regularly and for the same reason.” - Unknown

The continuing government shutdown and the impasse over the debt ceiling make this a stressful time for investors.  Particularly frustrating, as investment managers, is the impossibility of handicapping political martyrdom.

That said, our most likely scenario is that moderate Republicans will persuade Speaker Boehner to bring a “temporary” debt ceiling vote to the House floor.  Many believe that a majority exists in the House to pass such a measure today.  This legislation would likely be a stopgap measure to include a side agreement for future talks.  Over the last few days, Speaker Boehner’s camp seems to have delinked Obamacare from the debt ceiling debate, recognizing it is a political loser.  So future negotiations will probably be linked to entitlement reform and other spending reductions.

However, we believe that investors have been too sanguine about a resolution to this political drama.  There is no reason to think that President Obama and Speaker Boehner won’t go to the 11^th hour.  We would not be surprised to see heightened market volatility next week.

From its September 18, 2013 closing high of 1725.52, the Standard and Poor’s 500 Index fell just 4.2% as of Wednesday’s close, before rallying aggressively Thursday and Friday.  From a contrarian perspective, we would frankly prefer to see the market a little more panicked at this point . . . In a way, the equity market seems to be giving Washington the benefit of the doubt.  Perhaps investors concur with Winston Churchill, who once said, “Americans can always be counted on to do the right thing . . . after they have exhausted all other possibilities.”

Maybe investors are also remembering that we have seen this movie before.  In July of 2011, Obama and Boehner brought us to the brink of default over failed debt ceiling negotiations, resulting in a drop of 20% in the S&P 500 and also in Standard & Poor’s downgrade of U.S. sovereign debt from AAA to AA.  When the smoke cleared, markets recovered quickly.

Another possible factor behind the market’s complacency is that the consequences of default are so unthinkable that it is difficult to contemplate such self-destruction by our leaders.  But investors may be a little too comfortable with this consensus view.  Politics has become a narcissistic profession and stubborn pride could lead to great harm.

That said, despite dangerous ideology and extreme arrogance, we are cautiously optimistic that sense will prevail over mutually assured destruction.

At the height of the last debt ceiling crisis on July 26, 2011, we wrote to you that:

“Our highest probability scenario is that the government will act “in time” to raise the debt limit (a peculiar necessity considering Congress made the expenditure and revenue decisions which created the structural debt to begin with).” 

The atmosphere in Washington seems even more poisonous now that it was then.  However, given the backdrop of a financial crisis, a completely dysfunctional government and a sluggish economy, some amount of good news over the next few years should fuel additional interest in capital markets.  But, such frequent self-induced crises are enough to dampen our enthusiasm.

That said, frustration aside, we see an ultimate resolution to the crisis du jour.  Now is not the time to make rash investment decisions.  Nothing fundamental has yet changed and as a result we still believe that patience will reward investors who stick to their discipline (as has always been the case).

The Economics of Higher Education, Part 3: Why Do Fewer Blacks Graduate?

The Economics of Higher Education, Part 3: Why Do Fewer Blacks Graduate?

Help Wanted. No Smokers Need Apply

Help Wanted. No Smokers Need Apply: A Marketplace Podcast

Commentary on student debt crisis

Commentary on student debt crisis by Ben Cohen of Ben and Jerry's
http://www.cnn.com/2013/08/28/opinion/cohen-sallie-mae/

UPDATE: The New Emerging Market

by Matt Malick and Ben Atwater

From January of 2002 through September of 2007, emerging market equities experienced incredibly robust growth.  (“Emerging markets” is a label given to a group of immature, but fast-growing economies, most notably Brazil, Russia, India and China.)  During this almost six-year period, the MSCI Emerging Markets Index expanded by nearly 280%, which dwarfed the 33% return of the Standard & Poor’s 500.

As a result, financial advisors began to discover and then increasingly escalate their exposure to emerging markets.  In the minds of most investment strategists and market commentators, emerging markets were quite clearly the future and the trend would endure.



We all know what happened in 2008 - every stock market in the world swooned.  And then, they began to recover.

Over the past two years, though, emerging markets have faltered.  In defiance of conventional wisdom, since August 1, 2011, emerging markets have declined by more than 17% while the S&P 500 has surged almost 25% - a 42% performance differential.



Money flows have flip-flopped in favor of the U.S. for two primary reasons: (1) a quest for high-quality dividends in a low interest rate environment and (2) the perceived safety of the United States relative to the rest of the world.  Even within the S&P 500, we have seen stronger returns in recent years from companies that pay dividends and generate the bulk of their sales within the United States.

Since starting our business in 2008, we have been bullish on U.S. equities and our client portfolios, while globally diversified, have been positioned to take advantage of this expectation.  We anticipate that American equities will continue to lead in the near-term.  Cycles like these tend to reverse themselves only when they reach extremes in sentiment and valuation.  And at this point in the current bull market, many are still highly skeptical of equities, while the S&P 500 appears fairly valued, albeit not cheap.

The Road Taken

by Matt Malick and Ben Atwater

“Two roads diverged in a wood, and I – I took the one less traveled by, And that has made all the difference.”  -From The Road Not Taken, Robert Frost, 1916

In the spring of 2011, inflation expectations were high with commodity prices soaring and gold spiking.  At that time, Federal Reserve Chairman Ben Bernanke described these inflationary forces as transient.  Not too many people believed him.

A large number of diversified investment managers that implement a tactical asset allocation strategy increased their exposure to commodities - an inflation hedge - around this very time.

The 2011 drift to “alternative investments,” mainly commodity-centric ones, has been a regrettable asset allocation decision for many managers.  The Goldman Sachs Commodity Index has plummeted nearly 20% from its April 4, 2011 near-term high; while the price of gold has collapsed by more than 25% since its August 29, 2011 peak.

As a matter of fact, the overall trend among professional investors to avoid traditional U.S. stocks for the last several years has been disastrous.  Not only have managers emphasized commodities as an alternative investment, but they have also stressed “less volatile” vehicles because of an innate fear of markets.  Lo and behold, the experts largely abandoned the most conventional investment vehicle at the wrong time.

Through the end of May, the Standard and Poor’s 500, an index of essentially the largest U.S. companies, has gained an average annual return of 16.87% over the last three years.  Compare this to the aforementioned Goldman Sachs Commodity Index (energy, agricultural, metals, etc.), which returned just 4.79% annually over the same period.

Furthermore, the Hedge Fund Research International Fund Weighted Composite Index, a measure that includes about 2,200 constituent hedge funds of all varieties, returned 5.03% per year over these three years.  This is astonishing only in that a passive group of seemingly pedestrian stocks dramatically outperformed countless MIT PhDs and Harvard MBAs running hedge funds.

At the root of the mistake of underinvesting in the most traditional of asset classes (U.S. stocks) lay both sophisticated and simple reasoning.

Most basically, many investment managers looked at which asset classes performed the best in the five years prior to the financial crisis and assumed this outperformance would continue indefinitely, leading them to hedge funds, emerging markets, international bonds and commodities.  This analysis lacked the intellectual firepower of the most sophisticated asset managers, but the conclusions were the same.

The complex reasons for a forecast of below average U.S. stock performance stemmed from five major themes, all interrelated, that have yet to manifest themselves.  In our view, most major asset management organizations held these opinions and, as such, these views were the consensus forecast.

First, an expectation of inflation, and the repositioning of portfolios to reflect this anticipation, is the leading spoiler of investment performance for broadly diversified wealth advisors who implement a tactical asset allocation strategy.  After much fretting over central bank money printing – Bloomberg calculates that there have been 511 easing actions by central banks since June 2007 – inflation has yet to materialize.

Subdued inflation has allowed the United States Federal Reserve to keep short-term interest rates at 0%, while also purchasing $85 billion a month in long-term Treasury bonds and mortgage paper to suppress rates.  The ten-year Treasury bond pays 2.161%, while a thirty-year mortgage fetches 3.53% - extraordinarily low rates.  Therefore, the second prediction, which is part and parcel with the first, was that the Fed would not be able to maintain its amazingly accommodative policies this long, but they most certainly have.

Because most thought inflation would occur by now and because they then surmised the Fed would need to raise rates (stocks are less attractive as bonds pay more interest), experts have been broadly bearish on stocks.  The third mistake then, rather than allocating more dollars to stocks, managers have instead pushed more and more money into alternative investments, which have lagged core U.S. stocks significantly.

Ordinarily such low interest rates and a highly accommodative Federal Reserve would typically result in a weak dollar, the fourth common prognostication.  But, thus far, the dollar has strengthened - and markedly so over the last six months.  As a result, foreign stocks and commodities (because you can buy more of them with fewer dollars) have been laggards.

And finally, the fifth misstep was the assumption that slow U.S. economic growth would result in lackluster stock market returns.  Although seemingly logical, in reality there is little correlation between gross domestic product (GDP) growth and stock market returns.  With the United States consistently delivering below-trend economic growth over the last three years, the U.S. stock market has produced above average returns - much of which the Federal Reserve has made possible with its aggressive actions.  This takes us back to the first mistake . . .

UPDATE: The Gold Bear

by Matt Malick and Ben Atwater
 
On April 15, 2013, the same day as the Boston Marathon bombings, gold traded down 9.4%.  This was a significant technical (chart) breakdown.  But even before this drop, gold had already entered bear market territory. 
 
Three days earlier, on April 12, 2013, gold registered a loss of more than 20% from its high - the definition of a bear market.  It was a slow deterioration for the precious metal, as it took 599 days for gold to fall 20% from its peak.  According to Bespoke Investment Group, this is already longer than the average gold bear since 1975, which has been 483 days.  The average cumulative drop - peak to trough - has been 31.6%.
 
Bespoke further found that once gold crosses the bear line, the average number of days of additional decline is 309. 
 
Although gold is still down and out, it has, as of today, recovered the vast amount of its losses from April 15.  But, gold’s severe oversold level from April 15 was indeed historic. Since 1975, gold had never been more than 4.5 standard deviations below its 50-day moving average.  And in the eleven times it was nearly that oversold, more than 3.5 standard deviations, it had, on average, stayed depressed for the next six months. 
 
As you know, investors often view gold as a "safe haven" trade.  Therefore, if investors are selling gold, could this be a positive for stocks?  Again looking at the most oversold periods for gold from 1975, Bespoke found that over the next six months the Standard and Poor’s 500 stock index was up more than 70% of the time with an average gain of 7.08%.  Even very recently, since gold peaked in the summer of 2011 and then fell more than 20%, the S&P has climbed 40%. 


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