Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
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