Broker Check

Quarterly Newsletter January 2005

Quarterly Newsletter | January 2005


Our mutual funds and therefore our managed accounts had an outstanding quarter and year, once again. I attribute this to the asset class and mutual fund analysis at Belmont Financial. Every month, using Morningstar categories, we analyze over 50 worldwide asset classes considering both return and relative risk. From this analysis, we develop our tactical asset allocation, choosing at least 10-12 of the most attractive asset classes for maximum diversification. Then, we select the top performing funds in the most attractive asset classes, again considering risk and return. Fund management tenure and ethics are also factors. The resultant portfolios are extremely efficient, I believe, that is, they combine higher returns with lower risk. This analysis has led us to emphasize funds which invest in smaller companies and international securities, both stocks and bonds. Value style has been more attractive than growth. This has been the case for several years. Now, as before, many pundits are predicting the end of small cap and international dominance. Eventually this will happen and when it does, we will make gradual, not seismic adjustments.


A word on tactical asset allocation: Peter Bernstein, who has written 8 well regarded investment books and who at 85 has been called the “dean of investment counselors” said: “We need to throw out the old asset allocation model and become more flexible and ad hoc…” And Mr. Bernstein isn’t the only one. Other credible believers in “tactical asset allocation” include Yale economist Robert Shiller (author of the best seller “Irrational Exuberance”), former Morgan Stanley strategist Barton Biggs and institutional investment advisor Robert Arnott. The latter is a 5 time recipient of the Financial Analysis Journal‘s Graham & Dodd Scroll - considered the Oscar of financial analysis. Their common argument is that in an era of low returns – like the one most forecasters agree is upon us – investors need to be able to tactically allocate assets where the best implied returns exist and the risks are lowest.   


Things Felt Different Two Years Ago

In looking back on a good year, it is worth remembering back to early 2003 when even a decent year for the markets seemed to be wishful thinking. At that time, we were coming off of the most dismal year of the three-year bear market, and sentiment was extremely poor. Stocks continued to decline ahead of the Iraq invasion, the economic recovery had yet to gain traction, fears of deflation were starting to take root, and terrorism risk was on the front of investors’ minds. Amidst this backdrop, the emotional reaction was to get defensive. But the rational reaction was to look at valuations and recognize that the market was already pricing in what seemed to be an unreasonably high level of risk. In sticking to our discipline, we maintained our equity exposure and were rewarded with substantial gains since the market bottomed on March 11, 2003.


Some of the same big-picture risks from that time continue to impact my thinking today and some don’t. The threat of terrorism remains in the background, as may always be the case. The uncertainty of an invasion of Iraq is replaced with concerns about the costs and difficulties in trying to establish a working government there. The structural imbalances in the economy are now among the biggest worries. In particular, the potential of a dollar collapse, and the impact it would have on the rest of the economy, remains a meaningful risk. I say meaningful because, while I don’t think the chances of a dollar collapse are high, the impact would be broadly negative across the world economy. Our exposure to international securities, both stocks and bonds, serves as a partial hedge to this unlikely event.


The problem is that we depend on foreign capital to fund our current-account deficit, which is at an all-time high (the current account measures the balance of imports, exports, net investment income, and unilateral gifts between the U.S. and foreign entities). The dollar has declined materially already, and some experts believe a near-term correction where the dollar strengthens is possible. But most experts agree on the likelihood that longer term the dollar will decline further. A declining dollar could mean higher interest rates are required to attract the capital to fund our current account deficit. With many consumers already facing high household debt levels, including a lot of variable-rate debt, higher rates could depress spending as consumers lose disposable income to higher debt payments. It could also take the wind out of the housing market—reducing another positive influence on consumer spending. However, a lower dollar makes USgoods and services look inexpensive to the world, stimulating our export economy and correcting the trade imbalance.


This brings us to another concern that factored into our thinking 18 months ago: deflation. While a generally healthy economy and stock market have all but eliminated most talk of deflation, it remains enough of a possibility, despite the likelihood of gradually rising interest rates over the next few years. The reason is that the impact of a significant rise in interest rates would likely lead to a falloff in consumer and corporate spending and could result in a debt crisis, which could tip the economy into recession and even deflation. A debt-crisis or dollar-crash scenario would not be great for bonds in general, but stocks would probably do far worse. Again, I don’t view these scenarios as likely.


After two good years, it is easy to feel good about the markets and ignore the risks. And following a bad year, or three-plus bad years as was the case in early 2003, it is easy to overplay the risks (even as cheap valuations provided a big cushion). This inverted perception of risk and reward is what underlies the bulk of the decision errors made by investors. I view my job as ignoring the psychological impact of recent market performance and focusing on the fundamentals, both negative and positive, and there are plenty of positives or offsetting factors as well. For example, the economy is generally healthy with global economic growth near a 30-year high. Productivity growth has been a positive. The U.S. consumer may not be in as bad shape as many think: credit card delinquencies have declined, and household assets have risen thanks to strong home prices. Corporate earnings have been very strong, and most corporations have plenty of cash on their balance sheets, which bodes well for capital spending. Valuations aren’t as good as they were, but are still well within a range considered fair. So where does that leave us?


Domestic Equities

Given the strong run we’ve seen from equities over the course of the past two years, it’s not surprising that return expectations have come down. In a base-case five-year scenario, which assumes 3% average inflation and 5% average earnings growth, we look for equity returns in the mid- to upper single digits. I expect my rigorous analysis of assets classes and mutual funds to add to these returns, but there are no guarantees. In addition, there are scenarios, such as a dollar crash or a debt crisis that would likely result in much lower returns, especially over shorter time periods. And the interrelated threats of gradual inflation or deflation could also result in lower returns. I still believe the base case is the most likely outcome.


With respect to style, value has been dominant over growth since the bursting of the tech bubble in early 2000. In four out of the past five calendar years, the Russell 1000 Value has massively outperformed the Russell 1000 Growth. Value may overshoot, and current valuation work tells us that if anything growth stocks might be slightly more attractive at this point. Our discipline requires a clear performance advantage before making a tactical bet, and this is not the case right now.


Smaller-caps also have been great performers versus large-caps since 1999. However, by many measures smaller-caps are starting to look a bit pricey, though not clearly overvalued. Experts have been predicting the demise of small caps for years now, but this has not happened. We will keep our eyes open and make gradual adjustments when our analysis leads us in that direction.



Whereas the equity and commodities markets reflect a fairly good economic outlook, the very low real yields offered by investment-grade bonds are consistent with a consensus expectation for a weak economy. Given the low yields, big returns from bonds would require a meaningful drop in interest rates, which is unlikely with the Fed clearly in a slow-and-steady tightening mode. And with a massive budget deficit, bond supply is likely to increase, which should also put some upward pressure on rates. Foreign governments, particularly in Asia, have been huge buyers of Treasuries in recent years, but at some point their willingness to add to their Treasury positions will wane, and the resulting reduction in demand could also lead to higher rates. Analysis suggests that bond returns should still be in the low single digits on average over the next several years. Bonds continue to have a role to play as volatility reducers for conservative investors in the event of a bear market or as protection in the event that we tip back towards deflation. Lastly, there is a real chance that we will see only a modest rise in rates. PIMCO, for example, believes the rise in rates will be mild. High-yield bonds, one of my favorites for the last couple of years, had a good year. But the party may almost be over. International bonds continue to remain attractive and offer a hedge against the declining dollar.


International Equities

As I have been saying for awhile, on a statistical basis foreign stocks look cheap, but they have always sold at a discount to U.S. stocks, and undervaluation in the past has not always resulted in outperformance. Dollar weakness has contributed to the outperformance of international stocks, but this could change.



There are signs that the fundamentals are bottoming out and in some instances are actually showing small signs of improvement. But valuations appear to have more than accounted for this, and I believe the asset class is slightly overvalued. Institutional interest for real estate appears quite high and REITS are likely to continue to attract hot money, which could drive prices higher in the near term. Rising interest rates could also be a problem.


While we have been fortunate to have a generally good year once again with respect to our own performance, I remind our clients that this may not always be the case in the short term. But I am confident that by working hard to make well-reasoned investment decisions and staying disciplined we will be able to continue to generate above-average returns over the long term.


I would like to wish all our clients and friends a healthy and prosperous new year. I certainly appreciate your trust and confidence and especially would like to thank all clients who have referred family and friends to Belmont Financial.

Please contact me if you have any questions or comments. I look forward to seeing you during our periodic review meetings.  


Mike Durant, January 2005