We hope your Holiday weekend was a good one.
With the general negative sentiment and outlook surrounding the world markets over the past several weeks and months, we have to wonder how many “sellers” remain. If we go back to the basic underpinnings of what a market represents-a structure for exchange, dictated by constantly-changing supply and demand-what else would need to be “priced in” for more shares in various companies to be sold? That’s correct, companies with value and individual merits, as opposed to just index numbers. We have a tendency to forget this relationship as well as the one that strong pessimism and market troughs on a graph tend to appear together. The centuries-old “buy when you see blood in the streets” adage has been effective, although it doesn’t feel so positive at the time.
The fear of an always-unknown future or an inappropriate focus on lower-probability worst-case outcomes can distort thinking. The inundation of real-time financial data just perpetuates this, and more drama equals better news. Higher probability (read boring, predictable) outcomes are just not newsworthy enough for many. However, when reactive thinking guides financial decision-making, the results of those choices are often quite poor to extremely poor over time. If we were to do the opposite, and had made strategic investments at previous inflection points in history and (taking it as a given that timing would be at least a bit off to some degree, early or late), we would often have ended up in a much better position.
This may also help you, anecdotally, understand the moving parts behind not owning the “Dow” exclusively-which might temper some of these fears based on what they’re faced with on TV. Here they are… one by one:
We have been significantly underweight government bonds (which includes the world of U.S. Treasuries and the somewhat more attractive GNMA mortgage-backed issues and municipals). With the bellwether 10-year Treasury yield hovering a shade below 3%, rates do not appear especially competitive and look to be embedded with risk. What’s the risk? Being locked into such a low rate for a very long period of time, and, if/when rates increase, values of those bonds would drop severely. It’s difficult to imagine this not being a likely scenario with current rates being at historically low levels, our current debt situation and prospects for future inflation being higher than where they stand currently. Early this year, we entered into the inverse government bond position to take advantage of this belief. We somehow knew we’d be early (valuation approaches to investing often are), and the individual position has been somewhat volatile, but this “hedge” has significantly reduced the overall effective duration of the fixed income segment of the portfolio in the meantime… a good thing if you are not a fan of interest rate risk.
An overweight here remains valid in our minds. Interest rate differentials between investment-grade corporate bonds and treasuries (aka “spreads,” the usual way of measuring valuations in bond-world) contracted dramatically from their “blown-out” levels in 2008 to a more reasonable situation more recently. As these still remain higher than average, though, we believe there is additional room for capital appreciation-not to mention decent yield-compared to shorter-maturity bonds and cash alternatives. High yield bonds are an exaggeration of this same premise, with higher coupon rates outright and more dramatic compression of spreads, which has led to exceptional returns. With high yield rates where they are, we suspect this trend is not over. In times of recovery, default rates on high yield debt tend to peak and then lower/improve-which has already been happening. Positive news that we hardly hear much of.
We talk about diversification benefits a lot and why global bonds make sense in a portfolio. In fact, they’re one of the most important additions on an asset class-to-asset class basis for risk reduction. We’ve also been able to take advantage of an ongoing trend of improving credit quality in many emerging markets, where yields have tightened from “extremely high” to “fairly high” levels. This gives us the benefits of higher coupon income unavailable in the U.S., price appreciation from that spread improvement, as well as the tailwind of emerging market currency appreciation against the dollar in many countries. These factors are not unrelated to each other. This trend has been one of the most powerful in the global investment marketplace in recent years and one we expect to continue.
U.S. Large Cap Stocks
Many investors look at large-caps as the anchor of an equity portfolio. Hence, the fascination with the Dow and flashing red and green lights during the lunch hour. While these blue-chips remain an important part of an asset allocation, their significance has waned somewhat as new stories in mid-cap and international equities have taken on a much more prominent role. However, despite their often staid, boring veneers, many of these companies are the best in the world at what they do, possess huge cash coffers, earn a large and increasing portion of revenues from overseas and emerging markets, and own competitive and difficult-to-replicate brand-name advantages. All at a currently attractive price to other smaller and more volatile stocks, instead of commanding a premium price (as they have traditionally). No need to convince us-we’ve been and are overweight.
U.S. Mid Cap Stocks
Strangely, this wasn’t even an asset class until the late 1980’s, where it was carved out of a combination of the larger small-caps and smaller large-caps, probably for marketing purposes. That said, many of the companies in this fairly tight group have proven to have quite a few advantages: stronger capital positions, fundamentals and access to capital markets than small-caps, as well as more flexibility and growth potential than many large caps. This is an area we are seeing classic American innovation continue to take place; no wonder they’ve outperformed during the “lost decade.” Several of these companies (particularly on the “growth” side, such as specialty health care and technology) have truly become a sweet spot and our overweighted position continues to look appropriate.
U.S. Small Cap Stocks
Despite the tendency of small stocks to perform well during economic recoveries, our modeling has shown them to be fairly to more-than-fairly-valued, when compared to mid- and large-cap alternatives. This may be one of the reasons why small caps have not demonstrated the same level of strength as during prior recoveries. Additionally, slower domestic growth and “pickier” credit availability might prove to be headwinds for many firms. An underweight (no weight really) continues.
Last fall, we depicted the gradual evolution from a U.S.-centric investment universe to a truly globalized one. The culmination of this research was our choice to increase the level of foreign investments across the board-in keeping with their growing stature in the global “basket.” These weights over the last several years have been extremely effective in providing value-add to the portfolios in a period of less exciting U.S. returns. This year, turmoil in Europe has weighed on performance, but such shorter-term spurts are hardly unusual. The trend of increased transparency in overseas markets, and, more specifically, significantly higher expected economic growth in peripheral developed market and emerging market nations (think BRICs: Brazil, Russia, India, China… among others) gives us the important ability to diversify portfolios and take advantage of higher expected returns looking ahead. This is the simplest and most accurate answer to the occasional client question, “What do you do if stocks become expensive?” The answer-“Which stocks?”
We don’t have to remind anyone that the fairly small, specialized group of real estate investment trust securities differs dramatically from residential real estate. However, while REITs are a diversifier we’ve been able to take advantage of over the years, the asset class’ relative small size renders it prone to volatility from cash flows, the behavior of other sectors (namely financials and the broader credit environment) and investor sentiment-which can spawn more extreme undervalued/overvalued situations more quickly than in other assets. Currently, after an extreme in the former, we believe we’ve moved a bit further toward the latter. Given our valuation principles, a current “fair value” situation in many larger geographic regions causes REITs to lose out to better opportunities elsewhere, so our underweight here will likely continue. What we do own is focused on the REIT markets of the Far East, where fundamentals have been stronger and valuations more reasonable than at home.
Timing commodity prices is somewhat difficult. The task becomes even more challenging when you combine a basket of different and dissimilar goods together into an index. The S&P GSCI we track most closely to contains a fair amount of oil/energy exposure (due to the index’s weightings being derived by world production and trade). Despite arguments regarding the short-term vs. long-term availability of petrochemicals in coming decades, current demand from emerging economies is certainly increasing exponentially, and, as global economic expansion continues and domestic economy recoveries take better hold, demand will likely increase from those users as well. All bullish factors. Not to mention the geopolitical risks which tend to be what you’d call “asymmetric,” meaning that price spikes during world conflict or other one-off unanticipated events tend to occur in a much more extreme fashion than price declines do in calmer times. Not to mention the inflation-hedging characteristics. All-in-all, not such a bad insurance policy.
When you arrange these puzzle piece together into a portfolio, there is certainly much more to talk about than “What’s the Dow doing today?”
Personal income and consumer spending both rose in May, by 0.4% and 0.2% respectively. Because income rose more than spending, we are back on our path to a higher savings rate. Both numbers were more or less in line with consensus expectations.
Consumer confidence fell almost 10 percentage points in June from May according to the Conference Board number. The drop from 62.7 to 52.9 was far more dramatic than expected. Following the rise in both this series and the consumer sentiment numbers from the University of Michigan last week, Wall Street had expected a very small change in confidence.
The Case-Shiller House Price Index rose 0.8%, the first increase in about six months, but construction spending fell, which offset things in the housing department. Overall, mixed to poor showings following the expiration of the homebuyer’s tax credit should not surprise anyone, if one considers the hurried-up demand in the months prior.
The ADP employment survey was disappointing, as private employers added only 13,000 jobs relative to the 60,000 economists expected, but, surprisingly, this didn’t appear to affect the markets to a large degree that day (Wed.) as it was offset by stronger Midwest manufacturing numbers. Thursday’s new jobless claims were also up, which focused more attention on potential lawmaker action to extend benefits (which they didn’t prior to the holiday).
Friday’s official jobs report showed a loss of jobs (due in no small part to temporary census workers’ stints ending), and continues to reflect a mixed job creation environment. Private employers are hiring, just not at the pace some analysts expected.
The ISM index slipped in June, but remains improved from prior months.
U.S. stock markets were pummeled again due to the economic reports mentioned previously. The pain was equally shared among the large caps (S&P, – 5%) and small caps (Russell 2000, -7%), as investors fled all types of risk. Once again.
European stock losses were relatively tempered (-4%) as American news seemed to dominate the week. Japanese equities fared slightly better.
The 10-Year U.S. Treasury rallied in price as the interest rate fell to 2.95%, with strong risk-aversion buying. The assumptions behind accepting such a rate might not be short of extreme (as discussed previously). Despite a decent week for bonds in general, government issues outperformed corporates. Int’l foreign bonds, in keeping with their U.S. counterparts, gained about a percent on the week. High yield underperformed with the broader risk aversion.
Real estate suffered the worst losses of the week (U.S. REITs down 7%) with the mixed economic data, while the non-U.S. side in Europe and Asia only lost half as much. Commodities were generally negative, led by crude oil down 9%, presumably on economic growth concerns. However, gold lost ground, too, surprisingly.
Have a Great Week
Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.