September 6, 2011
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives. Kane Cotton, CFA, is chief investment strategist of Bellatore Financial, Inc., and Jonathan Scheid, CFA, is President and CIO of Bellatore Financial, Inc.
If this slow growth environment coupled with asset price volatility continues for (to steal a quote from Fed Chairman Bernanke) “an extended period,” what additional portfolio strategies might aid the overall risk/return profile of investor portfolios? More specifically, how do you manage investments in a sideways market?
Adding to the complexity of these questions is the uncertainty about whether inflation or deflation poses more of a risk going forward, whether corporations are overvalued or undervalued and, perhaps most critically, whether the U.S. will double dip into recession or if this is this merely a normal mid-cycle slowdown.
Clearly, there is a wide array of scenarios being debated among economists and strategists, and the outcome has large implications to portfolios. The likely outcome – one that has been playing out for much of 2010 and 2011 – is a market that, while volatile, grinds sideways for a long period of time.
In his 2007 release of Active Value Investing: Making Money in Range-Bound Markets, Vitaliy Katsenelson laid out a compelling case for a long enduring sideways market as the high valuation extreme reached in 2000 gave way to a secular decline in P/E ratios that is still occurring today. Valuations have been declining for 11 years! This isn’t new. Rather, this phenomenon has occurred fairly consistently throughout the history of the stock market.
Just consider the S&P 500 over the last decade. Earnings per share doubled, yet the market is lower than it was 10 years ago. This is because the price you pay for a dollar of earnings (i.e., the P/E ratio) has gone down. While the market looks fairly cheap on a forward-earnings basis, 10-year normalized earnings do not. Further P/E contraction in the future will only enhance the probability of a sideways market going forward. More on this can be found at activevalueinvesting.com.
Here are five imperatives for constructing portfolios for the sideways market ahead.
Strategy 1: Know the role of cash
Cash may have a place in a portfolio, but investors need to accept that cash is a negative real-return investment! Unless deflation takes over, cash will offer negative real returns until mid-2013. Bernanke has told us as much, since mid-2013 is the earliest targeted end date for the Federal Reserve’s near-zero short-term interest rate policy. Bank accounts, CDs and money markets currently yield less than inflation, so simply sitting on cash is a losing proposition for investors seeking positive real returns over time.
Should cash be avoided completely? No. Cash serves a purpose. Its value doesn’t fluctuate in nominal terms, and for people who are near or in retirement, the stability of cash has value above a simple interest rate. Understand, though, that this view of cash is from the planning perspective, not the investment perspective. If a client needs six months or two years of cash on hand, they should have that cash available regardless of the investing environment.
Looking at cash as an investment is different. Because cash currently earns a negative real yield, there is an investing cost to holding it. At the same time, holding some cash allows investors to take advantage of market opportunities as they arise.
There are alternatives to cash, but for the most part they lack FDIC guarantee and stability of principal. There are some high-yield savings accounts that offer FDIC insurance and principal stability (as Jerry Stiller’s commercials for Capital One promise) that pay savers around 1%, but of course, those rates are variable and lower than the inflation rate.
For those willing to take on the risk of shedding FDIC insurance and principal stability, some high-quality, ultra-short duration bond funds are worth a look. Look for funds that are liquid and have reasonable short-term redemption clauses. We have successfully implemented RidgeWorth U.S. Government Securities Ultra-Short Bond (SIGVX), which currently has duration of about 0.8 and a yield above 1%. It doesn’t beat inflation, but it’s better than most cash alternatives, especially money markets, albeit with the risk of no FDIC insurance.
A similar product that is available in ETF form is PIMCO Enhanced Short Maturity Strategy (MINT). As with any ETF, investors should not pay a premium market price over NAV and must be mindful that principal protection (or NAV stability) should be a top factor when selecting any cash alternative.
Strategy 2: Seek spread for real yield
In PIMCOs June 2011 Investment Outlook, Buy Cheap Bonds with Safe Spread, Bill Gross made a similar case to ours above, namely that cash and Treasury bond investing offers negative real returns very far out on the yield curve. The chart below plots real yield on the 5-year constant maturity Treasury. As of July 2011, that real return against CPI-measured inflation is negative. Looking at future inflation implied by TIPS yields against Treasury yields, one must go out 10 years on the Treasury curve to achieve a real positive yield of only 0.25% (as of August 24, 2011).
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