Broker Check

Quarterly Newsletter October 2005

Quarterly Newsletter | October 2005

The equity markets have generated fairly tepid returns year-to-date, but did relatively well in the third quarter. The S&P 500 rose 3.6%. Among the equity asset classes, foreign stocks were the big star of the third quarter. Even September, the worst month for stocks, showed a gain: The first time in 7 years. Most investment-grade bonds were slightly in the red, but foreign bonds fared somewhat less well due to appreciation in the U.S. dollar. For the quarter, our mutual fund managers did very well against their benchmarks, but our overall tactical positioning, i.e. asset allocation, in our models added value and contributed to their outperformance.

Market Overview

Stocks — There is no shortage of things to worry about these days: hurricanes in the Gulf Coast, housing prices, massive current-account and federal-budget deficits, strife in Iraq, rising inflation, and others. I share these concerns, and think about how these risks could impact the U.S.economy and markets in the near and long term. It’s tempting to give in to these fears and assume a conservative investment posture, but this would ignore another—and perhaps more important—variable, which is valuations. Valuations matter because they provide insight into what the market expects to happen, and sometimes those expectations are overly optimistic or overly pessimistic. When these situations occur, we can take advantage of these opportunities and reposition our portfolios to potentially enhance our long-term returns, without increasing overall portfolio risk. In fact, in some instances, such as when there is a “fat-pitch” opportunity, overall portfolio risk may be reduced. Another important and often overlooked consideration is that as human beings, most of us analyze the investment markets through an emotional filter. We feel the best at market tops and the worst at bottoms. We’re natural contrarian indicators. For example, many of us are in love with real estate now. A broken heart is likely in the future.   

Looking at the current market and using several different valuation methodologies, it appears that the S&P 500 is at the low end of a fair-value range and may even be undervalued. These valuation approaches assume an average level of risk relative to history. Often, history serves as our guide, but we’re careful not to put too much weight on the past since secular changes can make historical data obsolete. So if there are no major blow-ups or there is no major cyclical downturn, we’d expect average annual returns in the high single digits (potentially even low double digits) over the next five years. (Despite the short-term economic impact of Hurricanes Katrina and Rita, I don’t think a cyclical downturn is likely in the near term, though it is a real possibility at some point over a five year time frame.) I have seen other valuation assessments that suggest the market is not undervalued, but the methodologies in which I have the most confidence suggest that the market is either attractively valued or is pricing in a higher-than-average level of risk. The latter may indeed be the case, and that impacts our conviction level in assessing the overall market and our tactical positioning.

The market always prices in risk to some degree, but it seems likely that the market is presently pricing in a somewhat greater-than-average level of risk. I too believe that there is a higher-than-average level of risk, but this apparent valuation buffer gives me some comfort that investors are not ignoring these risks. If one or more of the risks come to pass, it would be bad for stocks, and losses could be material over a 12-month time frame. However, the fact that valuations are already reasonably attractive suggests that a big drop from current levels would lead to a buying opportunity. In the short-run, valuations seldom come into play as a backstop against losses; investors get scared and head for the exits, valuations be damned. However, the trade-off for that short-term pain would be that it would create an opportunity for better-than-average long-term gains.

Within the equity universe, international equities have several things going for them: improving fundamentals in some areas such as Japan and emerging markets, and higher dividend yields and slightly better valuations than in the U.S. But I see risks as well: poor decision-making by government policy makers, sluggish progress on structural reforms, dependence on U.S. demand for exports, etc. We’ve had a strong weighting to international funds and I prefer to let our managers sort out the best places to buy stocks. At home, small-cap stocks look a bit less attractive than large-caps, and most of the data I’ve seen suggests that growth and value stocks are within a fair-value range relative to one another (there is some evidence pointing to the attractiveness of growth stocks and after many years of avoidance, recently I added exposure to growth). REITs have had a good year but most measures suggest that they do not offer attractive valuations, and as such I do not think a tactical position is warranted. Although there may be the potential for net asset values to be further revalued upwards, I am not willing to bet on that outcome.

Fixed Income — Investments in the fixed-income world can be very tricky. For example, rising oil prices stoke fears of inflation, which is bad for bond prices, but at the same time there are concerns that high oil prices in conjunction with other factors (such as a slowing housing market) could slow economic growth, which is good for bond prices. Many statistics suggest the economy is going great, but the structural imbalances in the U.S. pose risks that could, at some point, cut the legs out from underneath the expansion. Economic forecasting is difficult, and calling turning points is even tougher. Even among the forecasters I hold in the highest regard there are diverging opinions about the direction of the economy. But while bonds are heavily impacted by the economic environment, fortunately we don’t have to be able to forecast that environment to intelligently factor fixed income into our portfolio weightings.

Bottom line, bonds can still play a roll in portfolios of investors who want to dampen volatility or provide a source of income. Obviously I am aware of—and sensitive to—the return prospects for different bond sectors, and prefer to let our fixed income managers allocate to various bond sectors, e.g. foreign, high yield, etc. So bonds are an important diversifier that help us manage risk. Even with their relatively low yields I expect them to generate returns in the 4% to 5% range, which would equal or outperform cash returns over the long run in most scenarios, including a “steady-state” environment in which we don’t see any huge changes in economic conditions.

We cannot fully protect ourselves against every kind of risk and there is always some chance of a sizable equity market loss. The problem is that the only way to completely hedge this risk is to have very low allocations to volatile investments such as equities. But even bonds are not a perfect solution (I can imagine bonds losing 5% or more in a dollar crash or stagflation scenario, and they could even lose money if the economy did unexpectedly well). That leaves few options other than cash, which under any circumstance does not offer attractive long-term returns. So trying to protect against all possible risks would result in a permanent, ultra-conservative asset allocation. That level of excessive pessimism can be even more detrimental to long-term returns than market disruptions: missing big up-moves can seriously reduce long-term average returns. As always it is very important to make sure you are in the right type of portfolio for your level of risk tolerance.

 A Sell Discipline is Important

“……Some mutual fund investors are having a hard time facing the truth. At issue are billons of dollars residing in huge stock funds with wretched returns,” writes Jonathan Clements of the Wall Street Journal. These funds are run by some of the country’s best-known fund companies, including Fidelity and Vanguard. Sound grim? It gets worse. Among the laggards are 48 funds with $192 billion that have trailed their category average over three, five and ten years! The three-strikes camp includes today’s poster child for underperformance, Fidelity Magellan. Magellan has fallen behind even the poorly performing S & P 500 in seven of the last 10 years, but it continues to boast $55 billion in assets. Arguably Magellan is so big that no manager, no matter how talented, could generate stellar results. Why do investors stick with these laggards? One possible explanation is taxes. But about 40% of mutual fund assets are in tax-deferred accounts. And as my clients and friends know, fear of paying taxes is never a good reason to hang on to a lousy fund. Another problem is the “buy and hold” mantra that’s been drummed into our heads by the financial press and mutual fund industry over the years.

To understand why investors don’t sell, we need to look at investor psychology. “My guess is that most investors are unsophisticated and they are going to hang on until they need the cash or they meet their goal”, according to a new study by Woodrow Johnson, a finance professor at the University of Oregon. Meir Statman, a finance professor at University of California, suspects this tenacity is driven by our reluctance to sell bad investments. Selling means admitting we’ve made a mistake and giving up all hope of better performance. “The reluctance to sell affects everyone, professionals and amateurs alike,” he says. “The difference is, professionals have a sell discipline.”  Buy and hold is not a sell discipline.

The use of the word “discipline” is meant to imply absence of emotion and to be effective, a sell discipline must be based on objective, measurable parameters. For example, at Belmont Financial, we base sell decisions mainly on performance and risk relative to a fund’s category. Only top performing, world-wide categories are used in portfolios. Do we consider taxes? Of course: In taxable accounts we consider the amount of the gain (a loss is always taken on an underperforming fund), the nature of the gain (short/long term) and the degree of underperformance among other things. On top of this, I overlay my familiarity with the underperforming fund and possible replacement funds. Minimizing taxes is an important, but secondary objective. The primary objective is to maximize your wealth over time. And the proven way to do that is to always be invested in top performing mutual funds in the most attractive categories (asset classes).

The world is a scary place and probably always has and will be. But yet with a world view and a disciplined (not emotional) investment process, I believe it is possible to earn attractive returns over the coming years.     Please contact me if you have any comments or questions.                                                                            I look forward to talking with you at our periodic review meetings. Thank you for your trust and confidence.

Mike Durant, CFP®, October 2005