Market Comment Q2 2012
A MARKET CONUNDRUM?
Despite the apparent success of a summit of Euro-zone leaders at the end of June, the financial pressure on Spain and Italy persists. Yields on the sovereign debt of these two countries are at or above 7%. If these yields persist, when existing debt is refinanced the debt service burden threatens to become too much to support. An increased interest burden would make it even more difficult for these countries to achieve sustainable fiscal balance. Even at lower interest rates, debt levels are expected to rise for years while the necessary fiscal adjustments are being made.
Since yields of 7% reflect the market’s dim view of the credit-worthiness of these borrowers, there is a chance that they could lose access to markets altogether. In fact, one could argue that Spain already has, at least to some extent. This is not something anyone wants to admit. In May, Spanish Prime Minister Rajoy said there would be no bail-out for Spanish banks. Within two weeks, he had arranged a “line of credit” with the European rescue fund while jibing his predecessor for not asking for one sooner.
At the summit, leaders agreed to extend Spanish bank’s loans of up to 100 billion Euros on terms more favorable than had previously been proposed. Markets were temporarily buoyed by the agreement, including the prospect of increased banking system integration. With the European Central Bank designated as banking supervisor, perhaps the pressure can be reduced on banks on the periphery that are losing depositors to Germany and elsewhere. Global stock markets rose 2% the day after the summit, which ended at 4:30am, June 29, Brussels time. Unfortunately, the optimism was short-lived. As shown below, spreads quickly reverted to previous levels.
While uncertainty is a fact of life, it is difficult to expect European businesses and consumers to increase their spending when the fate of the currency itself is in doubt. In fact, most rational actors would reduce their spending, which is what has happened. Shown below is actual and expected GDP growth for the Euro area through the end of the first quarter of this year. While there is some variation among estimates, the outlook is weak at best. Business indicators have turned further down during the second quarter.
So there are two major bugaboos with which investors must contend: Eurozone woes threaten a systemic banking crisis such as happened in the U.S. after the Lehman Brothers bankruptcy. And a European recession threatens to derail global economic growth.
Despite all this, U.S. stock markets have performed reasonably well. As of this writing, the S&P 500 stock index has increased about 7% so far this year. There are three possible explanations: stock valuations already have taken account of the risks, low bond yields are forcing investors reluctantly into stocks, or investors expect central bank activity to drive prices upward and are unwilling to miss the party. In fact, all three explanations have merit.
We have written before about the financial press and its propensity to dramatize every twist and turn of the economic news. The bad news is that the public is bombarded with information that may or may not have relevance to long-term investors. The good news is that the current economic and fiscal problems are well known. There is, therefore, a good chance that pessimistic scenarios are well discounted at current market prices.
Even after rising substantially since the lows of March 2009, U.S. stocks are attractively valued relative to corporate earnings, since they have also risen substantially. Shown in the chart is the price/earnings ratio for U.S. stocks since 1952. Looked at from this perspective, stock valuations are below the postwar average. No one can accuse the stock markets of Pollyanna-ish behavior. Stocks in Europe are even cheaper.
In the U.S. government bond market, nominal yields have never been lower. Adjusted for inflation, they have rarely been lower or negative, as they are now. Negative real interest rates are only appetizing to those who fear the worst. Perhaps understandably, that includes many investors. For others, the prospect of almost certain negative returns lures them, however reluctantly, into the stock market. The biggest risk bond investors take now is that inflation reappears. However remote this appears at the moment, in fact it is a policy goal of the Federal Reserve to make sure inflation is at least 2%—which is above the current 10-year yield. It is almost certainly the case that some investors in the stock market have fled this unappetizing prospect.
CENTRAL BANK STIMULUS
In late 2011, the U.S. Federal Reserve launched Operation Twist, a program designed to lower long-term interest rates. Shortly thereafter, the ECB launched its Long Term Refinancing Operation (“LTRO”) to support the European banking system. These actions followed previous rounds of “quantitative easing” that, in retrospect, are clearly correlated with stock market advances.
The stated goal of such unconventional monetary policy is, in part, to drive equity prices higher. From the chart, it does appear that the Fed has succeeded. Days before the Eurozone summit, the Fed announced its intention to extend Operation Twist through the end of this year. Many suspect even heavier central bank artillery will eventually be brought to bear given the recent weakening of economic indicators. Some investors have likely been trained to anticipate the impact on markets of such stimulus programs and each release of bad news seems to increase their conviction.
THE OUTLOOK: CONTINUED UNCERTAINTY
We all know that markets do not correctly anticipate the future. As the probabilities of various outcomes change, so will market prices. There is clearly a risk that a recesssion will undermine corporate profits or that Europe’s policy of “kicking the can down the road” will run out of time. However, markets are clearly not priced for perfection. What’s an investor to do? In the long run—ten years or longer—funds invested in equities almost certainly will outperform bonds. With an appropriate asset allocation, investors can withstand the likely challenges to their conviction in the months ahead.
In our recent communications, we have stressed the importance of asset allocation in the overall investment management process. In particular, in light of equity market volatility—which has been unprecedented at times since the financial crisis began—we remind clients to maintain asset allocations at levels that do not require the liquidation of equities to meet anticipated expenditures. This may mean that anticipated expenditures for the next five or even ten years should be covered from non-equity funds in the portfolio, namely bonds or cash.
For many clients, asset allocation reviews have resulted in our recommendation to reduce equity exposure, but for some it has been to increase it. Recommendations to reduce equity exposure are not made because we are pessimistic about long-term equity market performance. In the short-term, however, short-term risks continue to be elevated, as discussed in the accompanying article. One’s investment timeframe plays a critical role in these decisions as the effects of market volatility over a short period of time dissipate over longer periods. Of course, valuation is important too. It stands to reason that owning equities when they are cheap is more rewarding than when they are dear.
There is no one-size-fits-all answer to the asset allocation decision. Asset allocation is a blend of science and art. The science involves how to apply basic investment principles when combining asset classes in an efficient, cost-effective manner.* Diversification and equity orientation are basic principles for long-term investors. Diversification helps to improve return while decreasing risk. Equity orientation promises the possibility of greater wealth accumulation.
The art involves the use of judgment when incorporating the individualistic needs of clients into the asset allocation process. Personal preferences are subjective: if a client is uncomfortable with a particular portfolio structure, there is increased risk of abandoning the strategy and incurring potentially costly consequences. It is also important to consider the size and character of other assets held by investors. Pensions can be considered similar to fixed income investments, reducing the need for bonds in a portfolio. Nonfinancial assets, such as homes and privately-held businesses, also affect portfolio composition. Homeownership insulates individuals from fluctuations in the cost of renting, so it reduces the need for inflation-hedging assets in the portfolio. Owning a business, though, may argue for a lower equity position in the portfolio.
Our clients rely on our core investment principals as well as our wholistic understanding of their personal circumstances. The value of working with a financial advisor is in the application of science and art to your individual needs and preferences. Working together, we create the opportunity to achieve investment success.
*For this discussion, I am indebted to David Swenson’s Unconventional Success: A Fundamental Approach to Personal Investment, published in 2005. Swenson is Chief Investment Officer of Yale University, where he also teaches economics and finance.
Though the fiscal and monetary stimulus provided to the U.S. economy has been substantial, there is debate about whether the strategy is appropriate or effective.
One of our favorite market prognosticators, Barton Biggs, a long-time strategist at Morgan Stanley, passed away last week at age 79. Here is a quotation that expresses some small part of his wisdom.
“[T]here are no relationships or equations that always work. Quantitatively based solutions and asset-allocation equations invariably fail as they are designed to capture what would have worked in the previous cycle whereas the next one remains a riddle wrapped in an enigma. The successful macro investor must be some magical mixture of an acute analyst, an investment scholar, a listener, a historian, a river boat gambler, and be a voracious reader. Reading is crucial. Charlie Munger, a great investor and a very sagacious old guy, said it best: ‘I have said that in my whole life, I have known no wise person over a broad subject matter who didn’t read all the time—none, zero. Now I know all kinds of shrewd people who by staying within a narrow area do very well without reading. But investment is a broad area. So if you think you’re going to be good at it and not read all the time you have a different idea than I do.'”
We value your Comments
Please provide us your thoughts and suggestions, including content ideas, by emailing your portfolio manager or [email protected].
If you would like to receive The HeadInvest Quarterly by email, please e-mail: [email protected].