Download Second Quarter 2012 Commentary

Second Quarter 2012 Investment Commentary
Appropriately, the second quarter of 2012 closed
with a spike in volatility, this time on the upside, as
news out of Europe sparked widespread optimism
that fiscal and monetary cooperation in the region
could keep the worsening fiscal crisis from spinning
out of policymakers’ control. The S&P 500 Index
rallied to end the month up 4%, but lost nearly 3%
over the course of the quarter. Small- and mid-cap
stocks fared similarly, up 5% and nearly 3% in June,
but down 3.5% and 4.4% in the quarter,
respectively. Emerging-markets equities followed
the same pattern, up nearly 5% in June, but falling
8.4% for the second quarter as a whole. Domestic
investment-grade bonds once again dominated all
fixed-income categories in the quarter, up 2.1%.

Generally, we know there is no easy solution to
the problems of excess debt that almost all of
the developed economies are suffering from. It
is likely that taxes will need to rise and spending
growth will decline over several years.

We know that conflicting political motivations and
economic circumstances across nations in Europe
are a huge impediment in dealing with the crisis
there. The need for a fiscal union or fiscal
integration is central to the problem, but it
requires surrendering some control of country
budgets, tax policy, etc. Gaining agreement will
require heroic efforts on the part of politicians.
Germany’s concessions at the June 28 EU summit
suggest compromise is possible but very difficult
decisions and negotiations lie ahead so
uncertainty remains very high. All of this suggests
that a partial breakup of the eurozone is very
possible. We know that Japan also has a huge
debt problem (relative to GDP their debt is
actually greater than in the United States or
Europe), though to date there has been no
market focus on Japan.

We know that the United States has its own debt
and political dysfunction over both the short- and
long-term. Near term there is the potential “fiscal
cliff” of large spending cuts and tax increases
which, depending on how it plays out, is
estimated to reduce GDP in 2013.

We know that in the United States, recovery
continues and there has been improvement in
some areas. Housing is showing signs of a
possible bottom. The labor market has improved
a little, though more recent data has been less
encouraging. The economy remains weak overall
based on employment, consumer spending,
disposable income, residential fixed-investment,
household net worth, and overall GDP. This
weakness makes the United States vulnerable to
economic shocks.

We know deleveraging in the U.S. private sector
Investing Today
We continue to be very concerned about the same
problems we’ve written about repeatedly in recent
years. Europe seems to be close to either spinning
out of policymakers’ control, or nearing a trigger
point of more comprehensive and effective action.
As we go to press there are indications that it might
be the latter as Germany agreed to soften their
stance on direct capital infusions into Spanish
banks, and other measures which suggest
movement in the direction of more integration.
While the wrong outcome here could be extremely
harmful to global equity markets and the global
economy, the crisis is beginning to create some
opportunities. Emerging-markets stock markets
appear to be attractive and European stocks may be
becoming attractive. However, they are not yet a
full-fledged fat pitch. Context is always critical to
decision-making, so let us walk you through some
of what we think we know, what we don’t know,
and how this informs our decisions.
What We Know

We know that extremely high debt levels have
created a headwind to global growth resulting in
a weak economic recovery with risk of another
significant economic and market downturn.
is progressing (16 consecutive quarters of debt
reduction), but mostly through debt defaults.
We also know the financial sector has been
deleveraging on a quarter-by-quarter basis. This
progress is important, but we also know that this
process is by no means complete. We know that
if business confidence increases, U.S. companies
and many global multinationals not domiciled in
the United States will have large amounts of cash
and the potential to move quickly into a more
investment/expansionary mode.

We know that based on our analysis, Europe and
the emerging markets seem to be pricing in the
subpar growth world that we anticipate. This
means that even if this scenario plays out,
investors could capture reasonably good returns—
over 10% annualized in these regions. However,
our analysis indicates the U.S. stock market is not
fully pricing in this scenario and could only see high
single digit returns over the next five years for U.S.
stocks.
What We Don’t Know
The bottom line is that while we believe the subpar
growth scenario is most likely, we are not highly
confident in making this prediction. Not knowing
which economic scenario will play out is a big
unknown, but it is very helpful in our decision
making to be able to be honest about this and to
instead define and understand the range of
potential outcomes. Here are some of the key
unknowns:



Importantly, policymakers have the potential to
take actions that could have various outcomes,
positive or negative, for the global economy and
the markets—including actions that could trigger
positive market surges. While we think it is more
likely than not that their choices will be a net
positive, we are not confident which choices
they will make, especially given the politics
involved.
We continue to worry about the possibility of a
hard landing in China impacting the global
economy. Developments in the Middle East (e.g.,
war with Iran, etc.) could also significantly
impact oil prices. Neither of these risks are easily
analyzed.
As always, there are unknowable risks and
developments that could blindside us either
positively or negatively.
This all nets out to an investment environment that is
likely to be volatile, as was the case in 2010, 2011,
and so far this year, with periods of strong market
performance followed by sell-offs. These risk-on/riskoff periods are often driven by positive economic
reports or comments/decisions made by government
policymakers that result in investor optimism. But
soon thereafter, investors are reminded of the
magnitude of the debt problems we face. We
continue to believe that risk is high, even in our less
pessimistic, slow-growth scenario, with a meaningful
possibility of sizable market declines at times over the
next few years. However, forward-looking equity
returns are starting to look better, especially outside
the United States, mostly due to price declines.
More specifically our focus is now on the following:
Structure all balanced accounts so that risk is
somewhat below average. This will provide some
protection in down markets and importantly, will
leave us with some dry powder that we can redeploy if stocks get cheaper. It is important to
understand that our risk objectives focus on a oneyear time period. Over periods of less than one year,
the defensiveness in our portfolios may be less
effective. This is partly a function of higher-yielding
fixed-income investments that will earn a yield over
time and help support returns, but over shorter
(risky) time periods will probably underperform
traditional investment-grade fixed-income and
therefore potentially subtract value relative to
benchmarks.
Focus our fixed-income exposure on the best value
that also allows us to capture more yield. Loomis
Sayles Bond, PIMCO Total Return, and the Ishares
Investment Grade Corporate ETF are among the
funds we are focused on and collectively they have
added material value so far this year. We also
believe municipal bonds offer good value relative to
U.S. Treasuries.
Continue to be patient in waiting for more compelling
opportunities. As sell offs occur over the next few
years we will should be presented with fat pitch
opportunities, that should offer the kind of very
high return potential and reduced risk inherent in
different asset classes at a depressed price levels. In
the meantime, we will try to find the right balance
between capturing some return and making sure we
save enough dry powder to allow us to swing hard
when a fat pitch opportunity arises.
Many Questions and Some Answers
If we place ourselves in our clients’ shoes, we think
that given the turbulent investment environment
there could be a number of unanswered client
questions about our current views and resulting
portfolio positioning. We have taken the liberty of
posing and answering these here.
Q: You suggest that there is a possibility of a very
bad downturn. What would trigger that and how
do you assess that risk?
At this point in time, as already discussed, the
possibility of a disorderly partial or total breakup of
the Eurozone is the biggest concern and could
trigger a major global economic crisis and market
decline. A second risk is political dysfunction in the
United States resulting in an inability to address the
fiscal cliff at a time when the U.S. economic
recovery is still not strong. At its worst, it is
estimated that this could push the United States
back into recession. A third concern is a possible
hard landing in China. Most of the problems are
related to the need to reduce debt levels
(deleverage), which largely explains why we are
currently looking at a global growth slowdown. And
all this is going on in a global economy where
growth seems to be decelerating. These risks create
what some are referring to as bimodal outcomes.
Policymakers might get enough right so that they
take the worst-case scenarios off the table and we
muddle through. Or perhaps they even act boldly,
and business and investor confidence is restored,
leading to a much more positive environment.
However, there is that chance that things could spin
out of control. We can’t confidently assess the odds
of this happening. This is one reason why we have
emphasized with our clients that being in the right
portfolio type is important and is mostly a function
of their risk tolerance. Each of our portfolio types
are positioned somewhat defensively (except for
our most aggressive Equity portfolio), but it is the
model choice that will have the biggest impact on
capital preservation in a bad environment. For
investors who can withstand volatility and maintain
a long-term focus, we continue to believe that
stocks (particularly international stocks) are very
likely to outperform bonds over five years or more.
Our confidence in this forecast rises as the time
period lengthens. Stocks’ long-term appeal improves
on an after-tax basis. This view is more a function of
unattractive bond prices (especially investmentgrade bonds) than it is a statement about the appeal
of stocks.
Q: The Spielberger Group has been cautiously
optimistic for some time. How do you guard against
being too cautious?
It starts with regularly questioning our assumptions
and thinking about how we could be wrong. This is
also informed by exposing ourselves to a wide range
of views and being open-minded to understanding
why others might have different views than we do.
The fact that we interact with many highly
respected, intelligent investors in the normal course
of our business is enormously valuable in facilitating
this process and we believe it contributes to our
edge. Perhaps most important is that we know that
we can’t predict the future and this is why our
process involves looking at different economic and
market scenarios. This forces us to think through
both positive and negative outcomes. It is the
possibility of these positive outcomes that forces us
to maintain some exposure to risk assets so that
portfolios will participate somewhat if returns are
stronger than we expect. This is tempered by our
downside risk analysis that measures potential 12month loss exposure and forces us to make portfolio
adjustments if the potential losses could be
excessive.
Q: What is risk-on/risk-off and what is its
relevance?
This refers to a tendency for markets to have acrossthe-board reactions to big picture developments.
Good economic news or encouraging policy moves
can result in investors’ willingness to take more risk
so that all types of risky assets move higher. Usually
more defensive assets like Treasury securities and
the U.S. dollar move lower at the same time.
However, when big-picture factors are negative the
opposite occurs.
Our approach is to evaluate fundamentals and
valuations and form a long-term view. We do this to
avoid speculation based on short-term market
movements that tend to be driven by shorter-term
analysis or emotional market reactions. In our view,
shorter-term speculation is a much harder game to
win. So, the volatility related to risk-on/risk-off is
relevant to us in potentially three ways.
First, it is possible that the magnitude of the moves
in the market related to risk-on/risk-off could create
pricing shifts that make some asset classes more
attractive than others, triggering a tactical asset
allocation shift (i.e., fat pitch).
Second, we believe risk-on/risk-off has contributed
to very high correlations within the stock market.
This correlation has seemingly lessened the
influence of company-specific fundamentals on
individual stock returns and increased the influence
of macro-related developments that influence all
stocks—the result may explain the lengthy period of
poor performance on the part of active managers.
One measure: over the past three years only 16% of
Morningstar Large Blend funds outperformed the
Vanguard index fund that tracks the S&P 500 Index,
but over 15 years 41% outperformed. Those are
both poor numbers and build a strong case for using
ETF’s. The point though, is that in the recent period
it has been particularly difficult for actively
managed funds to beat the benchmark.
Third, the periods of fluctuating optimism and
pessimism can be confusing to investors. For
example, in each of the last three years there have
been strong market rallies early in the year followed
by market corrections ranging from about 9% to
19%. These volatile market conditions are one
reason why we make a consistent effort to remind
our clients and subscribers of our long-term
fundamental, valuation-driven approach that tends
to result in more gradual portfolio shifts.
Q: What is the fiscal cliff and how is it quantified?
The fiscal cliff refers to the expiration of tax cuts
and the automatic spending reductions, both of
which are set to be triggered in 2013. More
specifically, these include the expiration of the Bush
tax cuts and the payroll tax cut, new health care
reform taxes (3.8% on income above $250,000 for
joint filers), and the $2.1 trillion of spending cuts
agreed to last August. Another fiscal cliff contributor
is
the
planned
expiration
of
extended
unemployment benefits. The potential hit to 2013
GDP, if nothing changes, is estimated at between
3.5% and 4.5%, which exceeds the current real GDP
growth rate and suggests a high probability of
recession next year. Most political observers don’t
expect any new legislation to be passed until after
the election. We believe that a political solution will
be reached after the election to materially reduce,
but not eliminate, the fiscal cliff impact. However,
given the level of political dysfunction, we are by no
means confident in our view.
Wanting to Feel Better But Not There Yet
The fault lines in the global economy, mostly debtrelated, have not stabilized and are likely to be with us
for at least a few more years. There are no easy
solutions and we are all tired of it. We are also tired of
the risk-on/risk-off related volatility. It is confusing for
clients to see the markets roar for a month or more,
only to be followed by a surge in scary headlines and
sharp sell-offs. A disciplined, unemotional approach is
absolutely necessary in order to resist the emotional
pull of these ups and downs so that decision making is
not impaired. For long-term investors, the silver lining
we expect is that the price declines that could come
with these risks should generate good buying
opportunities. This is why we are retaining some dry
powder (in the form of more low-volatility investments
than would normally be the case) and it is likely we will
be able to deploy it over the next few years. This last
quarter we saw an example of sizable declines in
emerging markets and Europe. We acted only in a
small way because we continue to realize that while
long-term opportunities have improved, big risks
remain that we can’t, in good conscious, dismiss. We
continue to like what we own in the fixed-income
portion of our portfolio. Hopefully this will allow us to
capture moderate returns on this portion of the
portfolio while we wait. Other asset classes like REITs,
high-yield bonds, and commodities do not offer
compelling value at this time.
As always our motivation is to stay clearly focused on
our goals of long-term performance, risk
management, clear communication, and a high level
of service.
Mark Spielberger
Craig Brooks