Litman Gregory Mid-Year Commentary
Litman Gregory
July 24, 2012
KEY TAKEAWAYS
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. Large-cap U.S. stocks (as represented by the Vanguard 500 Index Fund) rallied to end the month up 4.1%, but lost 3% over the course of the quarter after declining 0.6% and 6.0% in April and May, respectively. Small- and mid-cap stocks fared similarly, up 5% and nearly 3% in June, respectively. While developed foreign stocks staged their biggest one-day rally of 2012 on the final day of June to end the month up 7.2%, they declined 7% over the quarter as a result of losses in April and May. 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%, and foreign bonds were up as well. We continue to believe Treasuries will offer poor returns, and have focused our fixed-income exposure on areas offering better values. Over the long term, we are confident the higher yields we capture will more than compensate us for the ground we would lose in a shorter-term market scare that drove a flight to Treasuries.
Recent market optimism aside, the debt-related fault lines in the global economy have not stabilized, and are likely to be with us for at least a few more years. We continue to be very concerned about the extremely high debt levels, particularly as they relate to the difficult challenges in Europe and our own looming fiscal crisis here in the United States, and believe that the debt-deleveraging headwinds will continue to hamper economic growth over the next five years. Despite the challenges, we continue to view our scenario-based investment process as particularly well suited to this very difficult environment.
However, forward-looking equity returns, especially outside of the United States, are starting to improve. We took the opportunity to add some dedicated European exposure at attractive prices in early June and incrementally increased our emerging-markets and broad-based international exposure. We acted in only a small way because we continue to believe that while long-term opportunities have improved, big risks remain that we can’t dismiss.
Our portfolio positioning is driven by a weighing of risk and potential reward and patiently assessing opportunities before investing more aggressively. As a result, our portfolios are not only somewhat underexposed to risk, but are also invested quite differently from their benchmarks. That makes it likely that our performance could at times significantly vary from underlying benchmarks.
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 of our long-term fundamental and valuation-driven approach that tends to result in more gradual portfolio shifts. A disciplined, unemotional investment 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 is that the price declines that could come with these risks will likely generate good buying opportunities, and allow us to generate better long-term returns than what the broad markets offer.
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. Large-cap U.S. stocks (as represented by the Vanguard 500 Index Fund) rallied to end the month up 4.1%, but lost nearly 3% over the course of the quarter after declining 0.6% and 6% in April and May, respectively. 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. While developed foreign stocks staged their biggest one-day rally of 2012 on the final day of June to end the month up 7.2%, they declined 7% over the quarter as a result of losses in April and May. 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%, and foreign bonds were up as well. We continue to believe Treasuries will offer poor returns, and have focused our fixed-income exposure on areas offering better values. Over the long term, we are confident the higher yields we capture will more than compensate us for the ground we would lose in a shorter-term market scare that drove a flight to Treasuries.
Our portfolios trailed their benchmarks in June, but remain well ahead year-to-date.
Litman Gregory has been writing its quarterly commentaries for over 25 years. In the years since the financial crisis began in 2007, writing these commentaries has become particularly challenging as a result of the:
- increased relevance of the macro environment and the need to explain complex relationships to an audience that varies widely in its understanding of and interest in these issues;
- potential for material events to occur so quickly that by the time a commentary is written, moved through our editing and production process, and then finally read at some future date, important events could have occurred, making some of commentary dated;
- number of relevant topics that impact the complete picture of what matters to our clients’ investment portfolios now and in the future, and the difficulty we face in choosing which topics to focus on each quarter since it is impossible to cover everything in detail.
We know that our commentaries tend to be long—the full commentaries often run eight to 12 pages. Some of our readers think this is too long while others express appreciation for the detail. We believe that the most important part of our commentaries is the perspective and context that we provide, which goes beyond the detail of analyzing current events. Often this is located near the end of the commentaries, so this quarter we are going to flip things around and start with our perspective before moving into the details.
The Essence of the Service We Seek to Provide
The period marked by the onset of the financial crisis has been unusually difficult for investors because, as we have written repeatedly, there is an unusually wide range of potential outcomes and the probabilities can’t be confidently predicted. Despite the challenges, we continue to view our scenario-based investment process as particularly well suited to this very difficult environment. We write about this process and our investment philosophy often, but this quarter we want to briefly discuss the service we seek to provide to our clients at an even more basic level. Our service is driven by what we would want if we were the client. Admittedly, the services we might seek could be different than what some clients may seek, because as investment professionals we have a context that comes from being in the business day-to-day and knowing what is and isn’t realistic. Our goal in hiring an advisor would be to establish a relationship that would last for our investment lifetime, and the following traits and skills would form the foundation of that relationship.
1. There must be complete confidence in the integrity of the advisor. In a world where regular headlines remind us that ethics are sometimes lacking in the financial services industry, an unquestioned commitment to the highest ethical standards is a must-have.
2. There must be complete confidence in the competence of the advisor. This is a function of:
- the advisor’s experience and history;
- the advisor’s investment philosophy and process, and whether it is thoughtful, thorough, and understandable;
- the advisor’s ability to think independently and their willingness to invest differently than others (and/or a benchmark when appropriate). Professional investors often exhibit herding behavior because there is safety in numbers. Good investors should be willing to invest based on their convictions, even when they are in conflict with the herd. This means that the strength of their convictions must give them the courage to temporarily appear wrong;
- the quality of the people employed by the advisor;
- the ability of the advisor to explain their analysis and decisions, and to admit mistakes (they will happen); and
- performance over long periods. Performance over short and intermediate periods is of minimal importance. As an evaluator of other investment managers, we know all investment managers, even the good ones, experience multiyear periods of under- and outperformance. (This topic has been well researched, including by Litman Gregory—please read our September 2006 study.) For skilled managers, underperformance is often followed by outperformance. These performance variations should be expected, especially if the advisor is willing to invest differently than the benchmark. But performance should be explained. Periods of underperformance should be tolerated if the client continues to believe that the reasons for having confidence in the advisor’s skill have not changed.
3. The advisor must understand the client’s goals, risk tolerance, and communication needs.
Every business in every industry must understand their customers’ needs. However, sometimes there is tension between what their customers want and what they need, and usually this tension has to do with shorter-term wants versus longer-term needs. In our business a client would certainly want to have strong performance in all periods. But given that this is not realistic, what they really need, in terms of performance, is competitive returns over the long run, relative to their risk/return objectives. Many firms in our industry approach this in different ways. Some choose to hug benchmarks so that they will never underperform by too much. Our view is that benchmark-hugging guarantees average long-term performance and also locks the investor into benchmarks that can at times be very risky over shorter periods without compelling return potential. So we believe over the long run, our client’s best interests are served by a willingness to invest differently from a benchmark when it makes sense to do so. This also means performance will vary (positively and negatively) at times relative to the benchmark.
Our approach throughout the life of Litman Gregory has been to focus on what we believe clients need most—solid long-term performance, which is consistent with their objectives, risk tolerance, and in the context of the market environment. While we have a five-year investment decision horizon, as investment managers it is fair to say that our performance goals are even longer term. We believe we have delivered on this goal. Looking at 138 rolling 10-year periods encompassing over 20 years, our Balanced Model (we use this as a proxy for overall performance since it is the most widely followed model) has outperformed in every 10-year period with an average annualized performance advantage of 140 basis points. Along the way there have been many shorter-term periods of underperformance. For example, over five-year periods the same portfolio has outperformed 70% of the time—so almost one third of the time it has underperformed. The worst five-year performance period lagged the benchmark by over 2% per year. However, since all 10-year periods beat the benchmark, this means that in the 30% of the periods where we lagged the benchmark, we outperformed in the periods that preceded and followed.
Why are we discussing this now? It is partly more reflection on having reached a quarter of a century in business and thinking about how we have conducted our business. It is partly because over the last five years we have slightly trailed our benchmarks. But mostly it is because we continue to view the investment climate as highly uncertain—fraught with risk and many short-term market spikes and drops—and will probably require the passage of years before any investment manager’s views and actions can be reasonably assessed.
Today, our portfolio positioning is driven by weighing risk and potential reward and patiently assessing opportunities before investing more aggressively. As a result, our portfolios are not only somewhat underexposed to risk, but are also invested quite differently from their benchmarks. That makes it likely that our performance during this period could at times significantly vary from underlying benchmarks. As always our motivation is filling our clients’ needs, which we define in terms of long-term returns, with much less worry about shorter-term performance relative to our benchmarks.
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. (We don’t have all the details at this time so we can’t comment on the significance of these proposals.) 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. By early June, the sharp sell-off in the European and emerging-markets stock markets had, in our view, fully priced in a slow-growth scenario that we believe is most likely. These markets are now very attractive relative to the U.S. stock market. However, they are not yet a full-fledged fat pitch on an absolute basis and in our more pessimistic scenario, which we do not dismiss (in fact we could argue that its odds have risen somewhat), they would likely experience a sharp sell-off. Consequently, we have stuck a toe in the water by adding dedicated European exposure in early June and incrementally increasing our emerging-markets and broad-based international exposure. 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. This risk has been turning into reality in Europe for a number of months and is reflected in an economic recession, which includes extremely high unemployment in the weak peripheral countries, slowing growth in the core countries, and a large decline in European stock prices.
- 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, and this will continue to be a drag on economic growth.
- 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. If that happens, the hope is that it will be well planned so as not to unnerve the markets, thus avoiding a possible credit freeze and increased capital flight, which would exacerbate the risk to the entire eurozone and trigger a major economic downturn. This scenario is a major worry and has been rapidly intensifying.
- 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 by 1% to 4.5%—a sizable amount. (The wide range of GDP impact is due to accounting for the probability that all measures might not be implemented.)
- 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 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. Overall debt levels in the private sector are still high, though debt service is low compared to incomes because of low interest rates—and this is a big help. And in the public sector, debt has been building—so deleveraging there has not yet begun but it will have to. Our deleveraging analysis last year suggested that the process could take another five years.
- 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. (See Ned Davis chart below.)
- 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 (we project sub-5% returns over the next five years for U.S. stocks in our subpar growth scenario). Though we have a high degree of confidence in our analysis, there is no guarantee that it is right with respect to the general level of returns we forecast. (See Five-Year Annualized Asset Class Return Estimates table below.)
- We know that in our worst-case scenario, our analysis projects negative returns over five years in global equity markets with this probably playing out via a sizable bear market along the way.
- We know that traditional investment-grade bond yields are so miniscule that very low returns are assured over the next five years. Our annualized return range for the asset class over five years across all of our scenarios is -0.6% to +1.7%. This being said, there are opportunities in certain fixed-income sectors.
Five-Year Annualized Asset Class Return Estimates
|
Broad Economic Scenario** |
|||
|
Severe Recession |
Stagflation |
Subpar Recovery |
Average |
S&P 500 at 1362, Barclays Aggregate yield at 1.9%, MSCI EM Index at 937, BofA/ML High Yield Cash Pay Index at 7.3%. |
||||
|
Estimated Average Annual Returns Over Next Five Years |
|||
Equities |
||||
U.S. Equities |
-4.0% |
-2.6% |
4.1% |
12.8% |
Developed International Equities |
||||
Japan |
Similar to U.S. Equities |
|||
Europe |
Similar to U.S. Equities* |
Similar to U.S. Equities at the low end to 3.5% at the high end* |
10.2% |
18.9%* |
Emerging Markets |
3.1% |
n/a |
12.2% |
21.9% |
REITs |
-1.0% |
-2.5% |
1.0% |
1.3% |
Fixed Income |
||||
Investment-Grade Bonds |
1.7% |
-0.6% |
0.4% |
-0.1% |
High-Yield Bonds |
1.8% |
4.4% |
3.8% |
2.3% |
Floating-Rate Loans |
3.7% |
3.6% |
4.4% |
4.2% |
TIPS |
1.8% |
-1.0% |
-1.0% |
-2.0% |
Emerging-Markets Local-Currency Bonds |
Low single-digit returns in the Severe Recession scenario; low/mid-single-digit returns in Stagflation scenario; mid-/high single-digit returns across Subpar Recovery and Average Recovery scenarios. |
|||
Alternatives |
||||
Arbitrage Strategies |
Mid-single-digit returns in most scenarios. |
|||
*Europe returns in these scenarios are subject to change pending further analysis. |
||||
**Scenario Definitions: |
||||
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 (because the consequences of bad choices could be truly awful), 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/risk-off 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. It seems to be déjà vu all over again . . . and again, and again. 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. While it is the same downer message we have been communicating for the last several years, at least we can say that forward-looking equity returns are starting to look better, especially outside the United States, mostly due to price declines. Overall though, all equities are subject to very high risk in our most pessimistic scenarios, and of the major markets, the United States is not pricing in the subpar growth world that we think is likely.
Given this context, we will continue to refrain from trying too hard to capture uncertain returns in a choppy, potentially very high-risk environment. But, we do seek to add value where we can while we wait for better opportunities. While we are not excessively defensive, we are conservative enough that we risk underperforming if the stars align: the eurozone pushes the right buttons, U.S. and global growth accelerates, and China avoids a hard landing.
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 re-deploy if stocks get cheaper. It is important to understand that our risk objectives focus on a one-year 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.
Maintain some exposure to risky assets but skew toward equity markets that offer a better risk/reward relationship. Specifically, though we are underweighted to equities, most of that underweight is taken from the U.S. equity allocation. We are almost at a full emerging-markets weighting, and if we factor in emerging-markets debt exposure we are over-allocated. And, we are only slightly underweighted to developed market stocks with some exposure dedicated to Europe. Based on our scenario analysis, the declines in emerging-markets stocks and European stocks created decent value so that returns even in a subpar growth world are pretty good. In short we are now being paid to take some risk. We remain somewhat cautious because there is still much tension between short-term risk and long-term opportunity. We believe there is a good chance that given the debt-related risks (especially from Europe), stocks will get even cheaper, perhaps substantially so. While they are not so cheap to be a clear fat pitch today, they have gotten cheap enough for us to begin to reduce our equity underweight in a small way. Please see our analysis of Europe in our June commentary for more insight into our thinking.
Focus our fixed-income exposure on the best value that also allows us to capture more yield. The more flexible fixed-income funds we hold in our portfolios will probably not help us as much in a market downturn as Treasuries, but we are very confident that they will be a source of major value added over our five-year horizon and even over much shorter periods (but not necessarily measured over a few months), as the higher yields we capture more than compensate us for the ground we would temporarily lose in a market scare that drove a flight to U.S. Treasuries. Additionally, we believe these flexible funds will perform much better if interest rates rise unexpectedly. DoubleLine Total Return, Loomis Sayles Bond, PIMCO Unconstrained, and Osterweis Strategic Income 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 though not relative to some of our more flexible fixed-income fund investments.
Diversify into some liquid alternative investments. These investments, which at this time are entirely in arbitrage funds, have the potential to provide somewhat more return than fixed-income investments (and potentially competitive with equity markets) over coming years at a level of risk that is likely to be quite a bit lower than the stock market.
Continue to be patient in waiting for more compelling opportunities. We believe it is likely that at some point in the next few years we will experience a market sell-off that will present us with a true fat pitch opportunity—one that offers the kind of very high return potential and reduced risk inherent in an asset class at a depressed price level. In the meantime, in our balanced portfolios, 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
Earlier we mentioned the challenge of deciding what, out of a range of relevant information, to cover each quarter. If we place ourselves in our clients’ shoes, as we did at the beginning of the commentary, 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: How do you make Europe-related investment decisions when there is so much risk and uncertainty?
We discussed our approach to evaluating Europe as an investment opportunity in-depth in our June commentary, and recommend reviewing that for readers seeking a more detailed discussion. To summarize, while we can’t predict what will happen, we recognize that the risk of a partial breakup of the eurozone is high and a full breakup is possible. We also believe Europe has the ability to manage a partial breakup, but the politics are extremely challenging. We know that risk keeps escalating with rising interest rates and capital flight from weak countries in spite of the various actions being taken to try to manage the crisis. (The agreement announced following the June 28 EU summit, though somewhat short on details at this time, should help buy Europe more time.) We also know that even if the eurozone stays intact, the southern European countries have uncompetitive economies that make it almost impossible for them to regain their competitiveness without sizable reductions in wages (losing the ability to devalue one’s own currency is a huge problem when a country joins a monetary union). Even Germany, Europe’s strongman, is affected because they export heavily to their weaker European siblings, and of course they are exposed through their banks and as the biggest provider of bailout capital. So we know economic and market risk is very high. Simply stated, our approach to investing in this risky environment is to require a very high expected relative-return premium before we would favor European stocks over U.S. stocks, and a high absolute return in order to really load up on Europe. In short, we need to believe that much of the risk is reflected in stock prices. In early June, with European stocks down over 20% from their 2011 high (which was already down significantly from their all-time high many years ago), we reached a point where the relative valuation justified a heavier weighting. At that time, in our base-case subpar growth scenario, the return differential (Europe versus the United States) exceeded seven percentage points per year with an absolute return expectation of around 12%. We viewed this as adequate to begin to increase our European exposure in a small way. (We are cognizant of much worse returns if the eurozone dismantles.)
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 investment-grade bonds) than it is a statement about the appeal of stocks.
Q: Litman Gregory has been pessimistic for some time. How do you guard against excess pessimism?
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 12-month loss exposure and forces us to make portfolio adjustments if the potential losses exceed the portfolio risk guidelines. (We are disciplined in following this process and it has served us well through our firm’s 25-year history, but there is no guarantee that we will get it right and at the beginning of the financial crisis we did violate our risk thresholds.)
Q: How underweighted to equities are Litman Gregory balanced portfolios?
Depending on the model, the underweight-to-equity risk is 5%–8% after the changes we made in June to increase exposure to non-U.S. equities. These numbers include an adjustment we make to account for equity-like risk in some asset classes. For example, we view emerging-markets local-currency bonds as likely to exhibit about half the downside risk as equities in a down market.
Q: Given below-benchmark equity exposure, how did Litman Gregory portfolios do in the market downturn that occurred in May?
The down market performance for our portfolios depends on many factors including how long and how deep the downturn is. In May, when stocks were down between 6% (U.S.) and 11% (non-U.S.), our balanced portfolios roughly matched their benchmarks. The fact that we didn’t outperform in May was driven by a couple of factors. First, our fixed-income funds in aggregate lagged the investment-grade bond index that is in our benchmark. This was as expected and we’ve written in the past that this would likely happen in a risk-off environment, especially over short time periods. Part of the appeal of these funds is their higher yield and over longer time periods (e.g., a year) that yield advantage will, we believe, trump the possible price underperformance in a bear-market–type environment (we expect this to be reflected in the blended performance of these funds). Second, on average our equity funds lagged their benchmarks in May. Together, these factors offset the equity underweight in the portfolios. Looking ahead, over longer market downturns we believe this is less likely to happen, primarily given the large yield advantage in our fixed-income funds. However, our portfolios are not positioned so defensively that outperformance in risk-on environments is assured or likely to be sizable (as mentioned, our equity risk underweight is only 5%–8%), and our recent moves to bump up non-U.S. stock exposure reduced our defensiveness at the margin.
Q: What is risk-on/risk-off and what is its relevance?
This refers to a tendency for markets to have across-the-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 (e.g., stocks, junk bonds, emerging-markets debt, real estate securities, certain currencies, etc.) 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 (i.e., cheaper) 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—but longer term they are consistent with expectations because the universe of large blend funds is essentially the market, but subject to higher fees than the index fund. The point though, is that in the recent period it has been particularly difficult for actively managed funds to beat the benchmark. This percentage should improve substantially as we move through this period.
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 (this is actually one of the largest items). 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. We would not be surprised to see increased investor nervousness later in the year as this issue begins to dominate the headlines.
Q: Some investment pros seem to think U.S. stocks are cheap. Why do you have a different view?
By some measures the stock market looks cheap, especially relative to interest rates. By other measures it looks to be in a fair-value range and by some it looks overvalued (e.g., price-earnings based on longer-term normalized earnings and also price-to-cash flow). However, the metrics the industry traditionally uses to value the stock market rely on various price-to-earnings measures relative to history. This is useful but if we are in an environment where earnings growth is likely to be slower than in the past, then historical comparisons could turn out off base. Our approach considers what earnings could be in different scenarios over the next five years and applies average multiples to those earnings (adjusted for the scenario). So, the range of possible earnings is important to our analysis. In that regard we continue to believe earnings growth will face headwinds. Earnings have been very strong in this recovery, and aggressive expense management has been one important factor. But there is a limit to how much profit growth can be squeezed from cost cuts, so we believe profit margins are likely to revert toward average levels (for the overall market, profit margins tend to revert to the mean). In addition, we believe there are other factors that could slow earnings growth in the next few years: 1) private sector deleveraging is a likely headwind that at best will be a neutral factor; 2) possible sluggish growth outside the United States, not only with respect to Europe but also to the extent the emerging markets are impacted by the European slowdown; and 3) perhaps the biggest factor will be slower growth in government spending, which we believe has been a material positive for corporate earnings growth. So, we believe there is a good chance that earnings growth will be subpar for several years and this is not fully priced into U.S. stocks. If we are wrong about this, then our analysis suggests stocks are now fairly priced instead of expensive.
Wanting to Feel Better But Not There Yet
The fault lines in the global economy, mostly debt-related, 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 and believe it to be far more attractive than the investment-grade index 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.
–Litman Gregory Research Team (7/3/12)
(c) Litman Gregory
