Broker Check

Quarterly Newsletter July 2004

Quarterly Newsletter: 
Sorting Through Uncertainty Is a Constant Challenge | July 2004

The second quarter was a volatile one. Interest rates rose and bonds suffered, with the Lehman Aggregate Bond Index down well over 2%. Small-cap stocks struggled and were barely positive on the quarter and foreign stocks, REITs, and high-yield bonds all posted slight declines. Larger-cap U.S. stocks did better.

As investors we are faced with a daunting task. Dealing with uncertainty is a given. We can never be sure what the future will look like. But even identifying the potential outcomes and sorting through all the big-picture variables and interrelationships is an enormous challenge. Being able to accurately predict the future on a consistent basis is not imperative to investment success. But understanding the possible outcomes and their odds is an important basis for determining a successful investment policy.

While no one is able to accurately and consistently predict the future, this doesn’t stop many amateur and professional investors from articulating scenarios with the clarity and conviction that could only come from a crystal ball. They wrap up all of the world’s complexity into a few neatly packaged investment themes. Often these strategists are highly knowledgeable and articulate, which makes their outlook persuasive. But persuasive or not, their predictions are often bunk. They carefully articulate a well-reasoned set of arguments that supports their position, while not mentioning the numerous and also compelling counter-arguments. So it is not surprising that they are often wrong.

There is value in hearing arguments that bear on an issue, since they stimulate thinking, but it is important to hear and consider all of the arguments. Trying to base an investment strategy solely on the ability to predict the “winning” outcome is not smart because it is unlikely that anyone will consistently get all of the macro calls right. One thing I have learned is that investing is a matter of assessing the odds and attempting to invest in ways that put the odds on your side. A valuation discipline is also a critically important part of success. It is also important to think globally. My monthly review of over 50 asset classes, considering both return and risk, keeps portfolios fresh and in tune with longer term global trends.

  • As part of risk and scenario analysis it is helpful to differentiate between factors that are likely to be of passing significance and those that are likely to be with us for quite some time. An example of a temporary factor is the corporate governance scandals that rocked the market at various times over the last few years. Instances of failed corporate governance were one of many faces of a long cycle of greed that peaked around the millennium. Corporate behavior is unlikely to degenerate to the levels we saw in the late 1990s until many years from now, when a new cycle of greed nears its peak. So this wasn’t something that factored into my risk analysis. Many of the issues investors tend to worry about on a day-to-day basis fall into the category of passing headlines, and therefore should be ignored by long-term investors (e.g. SARS). At the other extreme concern about high household debt levels does factor into our long-term thinking, because the debt problem is unlikely to be resolved quickly.
  • Think about variables and whether they are driven by the economic cycle (cyclical), whether they are secular factors (longer-term trends), or whether they are one-off developments. This helps to sort out the short-term/long-term significance discussed above.
  • Ask the question “What are the markets discounting?”  This ties back to valuation work and forces us to think about how much risk or optimism is built into market prices and therefore how much we may be paid to take on risk.
  • If there are risks we can’t analyze (in terms of probability and/or the magnitude of the risk), think about whether we can hedge some of the potential damage without hurting the long-term return potential of our portfolios.

Today’s Environment

Valuations: Each of the asset classes I follow is in a fair-value range except for investment-grade and high-yield bonds, which are slightly overvalued. Valuations are somewhat better than they were earlier in the year when they approached overvalued levels for many equity-type asset classes. The improvement is due to the decline in prices from peak levels and improving fundamentals.

The improvement is perhaps most noticeable with respect to U.S. stocks. The surge in earnings has led to an increase in base-case return expectations for the U.S. stock market. I now believe it’s possible that stocks could deliver a high single-digit to low double-digit return over the next five years (with volatility along the way) under base-case assumptions, which include an increase in the yield on the 10-year Treasury to 6% (currently about 4.5%).

Economic activity: With each passing month the economy gets stronger and it is becoming clear that the U.S. is in a full-blown recovery. Over the last year, real (inflation-adjusted) GDP grew at the fastest rate in 20 years. Though the level of economic stimulus will be declining and the economy will not maintain its recent pace, the general economic picture looks solid. The business sector is in excellent shape with exceptionally strong cash flow and improved balance sheets. This bodes well for jobs, capital investment, and the rebuilding of lean inventory levels because businesses have cash to spend and there is some pent-up demand. There has been more good news on productivity, which has rebounded to a very high level. Though productivity has a cyclical element to it, it held up remarkably well during the recession and has now moved higher, to a level not seen since the 1960s. The current level of productivity is not sustainable, but the evidence supporting a continuation of an above-average level compared to most of the last 30 years continues to build. This is important because it is one key factor supporting economic growth with moderate inflation. The big area of concern has been the labor market but that too is showing clear signs of improvement. Job creation has been very strong in recent months and is broad-based. Wage growth is also improving, but off of a very sub-par level. Consumer spending, which is of huge importance, has been healthy and if wages grow (as is likely) spending should be okay for the intermediate term.

Profits: In the current cycle, because profits suffered an unusually severe crash, the rebound has been almost as amazing. Profits have boomed. Cash profit margins are at levels not seen in decades, and the level of profits as a percentage of GDP, at over 10%, is extremely high. Obviously this won’t last forever—profit growth will definitely slow, but for the time being profits continue to surprise on the upside even while they slow. Unusually positive pre-announcements of earnings and a very high level of upward earnings revisions from analysts suggest that better-than-expected growth could last a bit longer. Earnings are strong outside the U.S. as well. Consensus expectations are for earnings increases around the world in line with the U.S. in 2004, with slower, but still healthy, low double-digit earnings growth forecast for 2005. If the 2005 numbers are realized, stock prices could do well over the next year

Interest rates and inflation/deflation: Inflation is picking up and rates have backed up in the bond market. Inflation has risen at a rate of over 3% over the past 12 months. Taking out food and energy, “core” inflation is 1.7%, but this also represents a clear increase. The bond market has anticipated this pick up and the 10-year Treasury yield has moved about one percentage point above its incredibly low level of last summer. The virtual certainty of the Fed’s raising short-term rates (which has now begun) has contributed to nervousness in the stock market. But it is important to understand that rates are rising because the economy is getting stronger, and this is reflected in rising profits. And rates are rising from such a depressed level that it is unlikely that the initial rise will hurt the stock market in a lasting way—especially since bond markets rates have already moved higher in anticipation of a short-term rate increase. Even the pessimists don’t expect a huge spike in inflation, but there is risk. The other worry concerns the interrelationship between debt levels and consumption. These in turn are linked to the possibilities of both inflation and deflation. Why do we care about debt growth? We care because if debt growth slows, consumer spending will also probably slow. And consumer spending is such a large portion of the economy that this could significantly slow economic growth and profit growth. And if that happens, we could again be flirting with deflation.

Near-term risks: I think of risks in terms of cyclical risks, structural risks, geopolitical risks, and sometimes, secular factors. These days the risks most often mentioned are oil prices and their impact on the economy, China’s overheating economy, terrorism, and interest rates. Some of these are harder to assess than others. But in general, outside of terrorism, I don’t consider these risks to be any scarier to investors than the risks faced at any other point in time (there are always risks).

We must assume terrorism risk will be with us for years. Any terrorist events may or may not have a long-lasting impact on the economy and the financial markets. It may result in caution over time on the part of investors that could keep financial asset prices lower than they would otherwise be.  A growing concern has been economic terrorism, which could have a more long-lasting effect. In general it’s hard to assess the chance that at some point the global economy will take a serious terrorist-related hit. Aside from the risk of an actual terrorist act, there are security and related military costs associated with the war on terrorism. The budget impact of U.S. involvement in Iraq is an obvious example.

Balancing out valuations, current economic fundamentals, and near-term risks we get to an okay, but not spectacular, investment backdrop. It is easy to allow risk to paralyze you, but the risks we can identify today, with the exception of the terrorism wild card, don’t seem worse than we’ve typically observed over the years. Financial asset valuations seem consistent with this observation. Valuations are fair, reflecting investors’ willingness to take some risk, and perhaps their recognition that this could be a benign cycle with satisfactory returns supported by only moderate increases in inflation and interest rates. At the same time there is not a high level of optimism priced into financial assets, as investors understand that there are risks, including the hard-to-assess terrorism factor. So things seem to be in equilibrium for now.

In Closing

This is not a time to be overly aggressive or overly defensive. It is a time to be patient. I believe that on average, portfolio returns are likely to be quite decent, though not spectacular, over the coming years compared to average inflation levels. But, there are no slam dunks. At some point along the way some of the risks discussed (or others not discussed) will turn into reality and there will be temporary losses. Investment success will require carefully evaluating global asset classes and allocating assets accordingly. The rapidly changing global economy and the creative destruction it brings make it unlikely we will ever return to the era of “buy a few good companies and hold em”.

Please contact me if you would like to discuss your portfolio or your investment goals. We continue to invest in the most attractive asset classes using the best no-load mutual funds available. 

Mike Durant 7/10/04