Monday, February 21, 2011

The new year started on a mixed note as January saw low single-digit gains across domestic large-cap and mid-cap stocks, and slightly negative returns for small-cap stocks (see benchmark returns table for full details). Looking abroad, large-cap international stocks were up 1% in January, while emerging-markets stocks dropped nearly 3% as concerns about unrest in the Middle East and high inflation in some emerging-market countries spooked investors. Turning to fixed-income, high-quality, intermediate-term bonds were flat through January, while the muni bond market dipped 0.4% on fears of muni defaults. Developed-market foreign bonds were also flat for the month, while emerging-markets bonds lost 1.6%.
 Research Team Q&A

We regularly use a question-and-answer format to address questions from readers about our investment views and current strategy. The Q&A format has the advantages of letting us address questions individually without worrying about being limited by a particular theme or subject and allows readers to focus on areas that are of interest to them. This Q&A piece was worked on jointly by members of our research team and addresses questions we received during the past several weeks. The questions are grouped broadly based on subject area, beginning with our broad views on the economy.

Q: It seems like the economy is improving, why do you still seem to believe that the recovery will disappoint? And if the macroeconomic news is still bad, why is the stock market continuing to reach new post–March 2009 highs, and what do you make of this inconsistency?

We’ll begin by quickly reiterating our macro views. (Note: a more comprehensive macro discussion can be found in last month’s year-end investment commentary.) We believe we are still in the early stages of private sector deleveraging. Debt levels have come down, but we think it is premature to assume that deleveraging has run its course. To offset this private sector retrenchment, the government has undertaken unprecedented amounts of fiscal stimulus. This has prevented the economy from crashing and it has also propped up corporate profits, indirectly. This does not seem sustainable, at least at the level we have seen thus far, and that’s important in assessing what earnings growth we can expect going forward. Our fiscal deficits and debt levels are already at very high levels, and as the European debt crisis suggests, there is a limit to what level of stimulus the market will allow, even for a large country like the United States. Ultimately, we believe that it is not only where in the economy the debt resides that matters, but overall debt levels matter too, and this debt has to be whittled down, which leads us to give more weight to our subpar economic recovery scenario, in which earnings growth is sluggish over the next five years.

There are a couple of reasons why the stock market has continued to go higher despite these macroeconomic headwinds. Very low interest rates are propelling investors to chase risky assets, and that has made valuations rich. Earnings have recovered strongly as well. As we’ve written previously, we never place a lot of weighting on shorter-term earnings paths or projections. Our goal is to assess likely earnings levels and valuation multiples five years out, and we complement this analysis with other valuation metrics and analyses to assess attractiveness of equities. Still, it is important we understand why earnings have recovered faster than we expected as it may influence our longer-term earnings projections.

Much of the earnings rebound over the past year or so has been due to government stimulus and cost cutting (which has manifested in high unemployment rates and historically high corporate profit margins)—factors which can’t be sustained. We don’t think it is prudent to assume that profit margins will remain at historically high levels for an extended period when they have historically shown a strong tendency to revert to the mean and we can see many reasons why this could happen. The other important driver behind strong earnings has been emerging markets. As we wrote in our year-end commentary, we believe this will continue to be a positive factor for many U.S. companies who are gaining an increasing share of their profits from sales to emerging markets, which are growing rapidly, offsetting at least some of the headwinds in the United States and other developed countries we have talked about. Given the many unknowns it is impossible to be certain about the magnitude of this emerging market “X” factor, so we will be assessing this on an ongoing basis. At this point, the positive impact of emerging markets on our more-likely scenario is only marginal, while in our optimistic scenario it is more significant.

So there are many factors, most of them unsustainable, that in the short term can cause earnings and the stock market to deviate from our economic scenario, but longer term we continue to think a subpar economic recovery will be a major headwind for corporate profits and the stock market.

Q: Your five-year return estimates look subpar across all the major asset classes. Is it possible one- to two-year returns could be considerably higher, and if so, are there any circumstances in which we’d take a larger weighting based on shorter-term expectations?

Of course it is possible that shorter-term returns for equities could be much higher than the annualized return expectations in our five-year base case scenario, and we have seen throughout history that markets can go far beyond (both on the upside and downside) what an asset class’s underlying longer-term fundamentals can justify. This is particularly true for a volatile asset class such as equities, where the potential range of returns in any given year is extremely wide. There are so many variables and factors that can influence stock prices in the shorter term (and we would consider one or two years to be shorter term) that we don’t have confidence basing our investment decisions on that type of time horizon. As we extend the time horizon for equities, we have more confidence that the underlying economic and business fundamentals will be reflected in stock prices (at least at some point within that time frame).

Our risk management process does involve a shorter-term time frame for analysis, typically 12 months. So in that sense we might make a tactical move for risk management purposes in response to a shorter-term expectation or perceived risk (e.g., we did this in the fall of 2008 when we sharply reduced our equity exposure as the potential magnitude and damage from the credit crisis became apparent to us).

But getting back to the question, we actually are actively debating and discussing some possible tactical moves on the fixed-income side based in part on our assessment of expected returns over the next year or two, rather than our typical five-year horizon that we use for equities. We will provide some more details on this below, but the bottom line is that we may conclude we have a high enough degree of confidence that the range of potential return outcomes is both attractive enough and narrow enough for certain fixed-income sectors over the next 12–24 months to warrant a tactical weighting. And the shorter-term outlook might be compelling from a risk/return standpoint relative to other asset classes currently in the portfolio, at least in certain scenarios. If that is the case, we would certainly consider a tactical move based on that shorter-term one- to two-year outlook.

But the key elements of this shorter-term analysis here, as with our normal five-year expected returns analysis, are that our decision will be driven by our assessment of the underlying asset class and economic fundamentals, we will be looking at multiple scenarios that we think are likely to or could possibly play out, and we will stress-test the downside risk of any tactical moves at the overall portfolio level in order to manage the risk of violating a given portfolio’s 12-month downside loss threshold. We focus on both the potential risks and returns in various scenarios.

High-yield bonds are an example of where our shorter-term returns are higher than our five-year forecasts. Looking at our base case scenario, our return estimate over our five-year investment horizon is in the 4% range, but over the next year, we think a return in the 7% range is more likely. There are two key reasons for our higher short-term return estimate.

First, we’re assuming interest rates rise over our five-year forecast period. As interest rates rise, this will put upward pressure on yields. As yields increase, prices of high-yield bonds fall. We think the timing of a rate rise is less likely in the near term but more likely over the full five-year window.

The second reason for the higher shorter-term return estimate is that we are assuming default rates increase further out into our five-year investment horizon. Defaults ended 2010 in the 3% range, below the historical average of 4%. Next year, the base-case assumption is for defaults to move even lower. But looking out over the next three to five years we expect a pick-up in defaults, given the maturity calendar. Defaults are a very influential input to high-yield bond valuations as they drive the loss of income/capital and influence spreads.

So it’s the combination of our expectations for higher interest rates, which put upward pressure on yields, and our expectation for higher defaults, and the fact that we expect these to happen later rather than earlier in our five-year window, that is driving the difference in short- and longer-term returns.

As we mentioned earlier, we don’t ignore the short-term projections, but we have to be intellectually honest with ourselves about our ability to accurately project what’s going to happen over any 12-month period for any asset class. For instance, looking at a range of economic scenarios, our range of outcomes for high-yield bonds returns over the next 12 months is as high as 10% and as low as a loss of 13%. Needless to say, that’s a wide range of outcomes.

U.S. Equities

Q: Given your view that stocks are expensive, at what point would you reduce your stock exposure further? Conversely, at what point would you add to stocks?

We are already quite underweighted to equities, so the hurdle to further underweight equities is higher. While we think it is not likely, we have to factor in the possibility that our optimistic earnings scenario might play out even if the U.S. economic recovery is subpar. One reason we mentioned earlier is emerging markets, which could be a major positive X factor for S&P 500 earnings over our five-year horizon. There are a lot of variables involved and it is a bit of a moving target, so it is difficult to precisely say at what level we will underweight equities more, but it is likely we will reduce equity exposure further when returns from our current optimistic scenario do not look appealing to us—in other words, when likely returns are mediocre to poor across all our scenarios.

As for when we would add to stocks, our estimated fair-value range is 800–1,100, with a fair value point around 950. Given the current level of our underweighting, it is likely we will add to equities as we approach the upper end of this range. Of course, markets could go sideways for a while, and during that time our fair-value range will shift up as we roll forward earnings in our five-year investment horizon, so we may end up adding to equities at a higher level. In addition, our fair value analysis is not static. We are continually assessing new information that might impact our scenarios and assumptions; any change in either may impact our fair-value estimate.

Q: Some investors view stocks as cheap because the earnings and cash flow yields compare so well to cash and bond yields. Is this comparison valid?

We think this is an unfair comparison for a few reasons. First, it does not factor in the fact that equities typically have significantly more downside risk than bonds. In addition to looking at relative returns across asset classes, we also look at whether or not absolute returns justify the downside risk we are taking in our portfolios. For us a potential return of around 9% in our more-likely scenario gives us enough compensation to consider a neutral position to equities, assuming there aren’t other asset classes that offer better risk-adjusted returns. But, why should we accept a lower absolute return on equities if we can get at least mid-single-digit returns that come with much lower downside risk? That is one of the key reasons why we have been as underweighted to equities as we have been. For example in 2008 and 2009 it was high-yield bonds and in 2010 it was emerging-markets local-currency bonds that, as expected, gave us equity-like returns but with much lower risk. This helped reduce the opportunity cost of underweighting equities and allowed us to outperform our benchmarks despite a strong stock market and with a lower overall portfolio risk exposure than the benchmarks.

Second, many investors tend to use forward estimates of operating earnings which makes earnings yields more attractive than they actually are. Operating earnings in our view tend to be overly optimistic and not reflective of true economic earnings longer term.

Lastly, comparing current low bond yields to earnings yields may prove to be a mistake if rates normalize in response to the economy normalizing, as it seems the market is discounting in equity prices. However, if rates remain abnormally low for an extended period, then they are likely low because we are still facing deflationary pressures, which is normally not good for equities. Neither rate scenario seems appealing for equities.

Municipal Bonds

Q: Could Meredith Whitney, who is predicting massive municipal defaults, be right?

The answer is we can’t say for sure that Whitney is wrong, but we are intensifying our research to make sure that we consider her points and account for them in our analysis.

As a quick background, Whitney is a banking analyst who has most recently gained notoriety for her assertions that massive levels of municipal defaults will be the next chapter in the credit crisis.

We are relying on muni bond managers for a lot of our market intelligence, but with that, there is a risk that their own biases may be coloring their comments or even their own beliefs. Understanding that, we’re continuing to look for unbiased contacts as well as views that are in line with Whitney’s in order to better inform our opinion.

The individuals we have spoken with think Whitney’s view is too extreme. Some are calling her “campaign of fear” irresponsible, which they say is driving lots of retail investors to make the decision to exit investments that are predominantly investment grade, and ultimately have little chance of default. But assuming she is wrong and the consensus is right (or at least closer to right), there remains the potential for the headline risk issue to play out. If there is a high-profile muni default, the headline risk could trigger a lot of selling (in light of what we’ve already seen). Meanwhile, there are others who don’t agree with Whitney’s default forecast, but think the headline risk will be huge.

It is possible that there will be enough contrary reaction to Whitney’s statements that will make it into the financial media to keep people calm, and we are increasingly seeing this. For example, we’re seeing more commentary refuting Whitney’s forecast, and we’ve heard that analysts are now calling for public disclosure of the details behind Whitney’s report given the additional costs her report has put on state borrowing and the investor losses prompted by her commentary and subsequent media coverage.

While it seems probable that we will see an increase in local government debt defaults, it does not appear likely that these will be widespread. They will generate headlines though, and that may trigger temporary sell-offs in the municipal bond market. Continuing to monitor the muni market remains a high priority for us.

Q: Are you worried about a run on the funds you use?

We are reading reports of mutual funds selling holdings to raise cash in anticipation of redemptions. DWS has been experiencing outflows in its Managed Muni fund over the past two months, consistent with industry flows, but inflows are also still coming in. Therefore, DWS has not felt it is necessary to build up their cash position. This is something we will continue to monitor.

Q: Given the recent sell-off, does the municipal bond market represent a tactical opportunity, or are current valuations justified based on the risk and uncertainty in the market?

The yield of the muni index is 4.27%. Adjusting for a 35% federal tax bracket that’s a tax-equivalent yield of roughly 6.5%. Historically, these levels have proven enticing to individual investors. Obviously, at these levels, the risk/return trade-off in the muni market is getting more favorable. Yet, it’s likely that this debate about state and local budgets still has a long way to go and will likely generate a lot of headlines. For now, we continue to rely on and believe in our active muni managers’ ability to navigate the credit risks in the muni market.

Emerging Markets

Q: How might emerging-markets inflation affect PIMCO Emerging Local Bond’s performance and do these inflation trends affect your views on the asset class?

The quick answer is that it depends upon the type of inflationary scenario we are getting. Before investing in PIMCO ELB back in August 2009, we factored in two inflation scenarios. In one scenario, we assumed food and commodity price inflation, which is what we are getting right now in many emerging markets. In that scenario, over our five-year investment horizon we estimate returns slightly above mid single digits, which is lower than in our base case scenario but still decent. In a more extreme inflation scenario, which we think is unlikely, we assume some emerging-market countries make policy mistakes and let inflation get out of hand. In this scenario returns would be even lower, probably in the low single digits, but it would be far from a disaster. In both scenarios it is likely returns in the short term would be poorer, but longer term the higher yields will help cushion the capital loss. Also, in both scenarios we are not baking in significant currency appreciation, and there is a possibility we are surprised on the upside on the currency front. This is possible because other than raising interest rates, currency is one of the policy levers emerging-market countries can use to tackle inflation.

Fixed Income

Q: Many of your fixed-income funds, like Loomis Sayles Bond and Osterweis Strategic Income, have performed well in spite of pessimism about future bond returns. Do you think they can continue to perform as well?

Loomis Bond: We continue to like Loomis on a long-term basis, while being aware it is riskier than our other fixed-income holdings and than a typical investment-grade bond fund. We think we will continue to be paid for accepting the shorter-term volatility though. We like the bond-picking expertise of Loomis, and currently the fund has about one-third of its assets in high-yield bonds, mostly at the upper end of the junk quality spectrum. That’s close to the fund’s maximum allowed in high-yield of 35%. We also like the non-dollar exposure we are getting in the fund—roughly 32% of the fund, with about 22% in so-called commodity currencies, such as Canada, New Zealand, Norway, and Australia, with most of the rest in emerging-markets currencies. The fund has almost no exposure to Treasuries or Agencies, so although its stated duration is 6.2 years, its actual downside exposure to rising interest rates is probably lower than that; rising rates might be a reflection of stronger economic fundamentals, which should be good for the fund’s credit/high-yield exposure. The fund’s average current yield is around 5.5%.

Osterweis Strategic Income: Osterweis was up just over 10% last year. We, like everyone else, are thinking about our fixed-income exposure in what we expect to be a rising interest-rate environment.

Specific to Osterweis Strategic Income, Kaufman continues to focus on balancing risk aversion with opportunistically seeking returns. Although there are no longer opportunities as compelling as there were in late 2008 and early 2009, he is still finding enough bond issues from well-run companies that offer reasonable returns without going too far out on the risk or duration curves. True to his process, he remains unwilling to lower his quality standards or to take excessive interest rate risk at this time in order to increase returns.

As for portfolio activity, over the past six to nine months, Kaufman has been opportunistically shortening the fund’s duration. This is not a wholesale move, but rather an incremental shift. For example, not long ago, Kaufman was selling longer-dated, equity-sensitive convertible bonds that appreciated during the market’s run-up, and using the proceeds to opportunistically buy high-coupon, non-investment-grade intermediate-term bonds. Kaufman is continuing to identify so-called cushion bonds, which are very high-coupon bonds. The fund’s yield to maturity is currently about 6%, and duration currently in the 2–2.5 year range.

Kaufman is also holding 10% cash, and is putting that cash to work as he identifies attractive investments. If the bond market corrects, and yields increase, he plans to more aggressively put that money to work, opportunistically, at higher yields.

While we continue to think Osterweis Strategic Income can perform well in 2011, we don’t expect returns to be as high as last year.

PIMCO Unconstrained: PIMCO Unconstrained is another flexible fixed-income portfolio holding that has the potential to perform relatively well in 2011. We just completed a fund update call with portfolio manager Chris Dialynas, and are publishing the write-up this month. The portfolio is getting very interesting in a couple of dimensions. Most significantly, the fund’s duration is now under one year. Dialynas brought the duration sharply lower in December (from three years to a little over one year) after the federal tax deal was announced. The tax deal basically made PIMCO more bearish on interest rates, both because of the higher cyclical growth prospects from the new stimulus and the fact that it worsens the federal deficit and will require the government to issue even more debt to finance the tax cuts and stimulus. Dialynas told us he has continued to bring down the fund’s duration so far in January. He also said he’s getting to the point where he’ll be considering a negative duration for the fund, possibly in the next few months. So the Unconstrained fund should be well positioned to weather an interest rate rise. The other key element of the fund is its significant and increased weighting to emerging-market currencies (primarily China and other Asian countries), which reflects PIMCO’s long-term view that the dollar has to depreciate relative to these currencies based on their relative fundamentals. Emerging-markets currencies are now about an 18% weighting in the Unconstrained fund. The fund also has an increased weighting to dollar-denominated emerging-market sovereign and corporate bonds. Dialynas says he is continually adding to the emerging-markets corporate bond position as attractive new issues come to market. Finally, he thinks Build America Bonds are very attractive at their current yield spreads relative to Treasuries and high-quality corporate bonds.

We think that this strategy, with its very flexible mandate backed by PIMCO’s deep team and expertise, can continue to perform well and navigate the bumpy road for fixed-income markets that is likely ahead.

Commodity Futures

Q: Commodities are heating up again—what would lead you to reintroduce an allocation to commodity futures in your portfolios?

We continue to evaluate commodity strategies, both the traditional long-only index strategies as well as some of the newer “rules-based” index strategies, such as the United States Commodity Index Fund (USCI) based on the SummerHaven Dynamic Commodity Index.

When we did our original research on commodity futures as an asset class back in 2003 and 2004 we concluded that a diversified long-only commodity futures index, such as the Dow Jones-AIG Commodity Index (now Dow Jones-UBS Commodity Index) could add long-term value to a traditional balanced stock/bond portfolio both from an expected return and risk reduction/diversification standpoint. We bought a position in PIMCO’s Commodity Real Return fund (which tracks that index) in January 2005 and held it until March 2008, and we earned a nice excess return on that position relative to stocks and bonds. We sold the position in 2008 because we saw a more attractive investment in emerging-market local-currency bonds and because we had become increasingly concerned about the risk of an economic slowdown coupled with the sharp upward (and possibly speculative) spike in commodity prices.

At the time, we wrote that we expected to invest in commodity futures again in our portfolios, once our concerns about the shorter-term environment were alleviated, based on our analysis that commodity futures would likely add longer-term value. However, over the past year or so we have been rethinking the potential longer-term value of owning a long-only commodity futures index fund. (We are still in process of this reassessment and have not reached any firm conclusions yet.) As the asset class has gained in acceptance among investors and the number of investable funds/ETFs has proliferated, it raises questions as to whether and to what extent the historical risk/return and correlation characteristics that we based our original analysis on will hold going forward.

For example, much of the commodity futures index has now been in contango for quite a while. This presents a headwind to potential returns—due to a negative roll return (or negative “yield”) from rolling over the index’s commodity futures contracts each month—although it does not mean the total return can’t still be positive if commodity spot prices move higher enough to offset the negative roll return. Some newer commodity index strategies attempt to minimize the contango headwind, and as mentioned, we are looking at those.

It also seems very plausible to us that the increased money flows into commodity futures as it has become a more mainstream asset class has reduced the historically observed risk premium that long-only commodity futures investors should in theory earn in exchange for absorbing short-term price volatility from commodity producers who want to hedge their price risk.

In addition, as commodities have become more of a mainstream asset class in investment portfolios their performance may have become more correlated to other traditional risk asset classes, such as equities. This was certainly the case during the financial crisis of 2008–2009, when both stocks and commodity funds plunged sharply, and also during the market recovery in 2009 and 2010. Given the fears of a global depression and deflation in late 2008–early 2009, we aren’t surprised commodities performed poorly because they tend to perform in sync with economic cycles. But we are not sure the diversification argument for commodity futures is as strong as we originally thought, at least in the kinds of environments in which a diversification benefit would be most material. This is a question we will be assessing more deeply.

                  —Centurion Advisory Group Research Team (2/1/11)

Tuesday, February 8, 2011

A New Pharaoh?

IN SPITE OF ECONOMIC CONCERNS, THE PUBLIC MARKETS continue to do well. By the numbers, for the two weeks ended Friday, February 4, 2011, the Dow Jones Industrial Average closed at 12,092, up 221 points, or 1.8%. The Standard & Poor’s 500 closed at 1310, up 27 points, or 2.1%, and the NASDAQ Composite closed at 2769, up 80 points, or 2.9%.

As noted, the DJIA has closed above 12,000 for the first time since June 2008, and the S&P 500 above 1300 for the first time since August 2008. Many are suggesting the market is overpriced. At the same time, Jeremy Siegel recently told an audience that the equity markets are still 20% below their long term trend lines. Professor Siegel tracks the domestic equity markets to the beginning of the 19th century. Our observation is that there is still much fear and concern regarding the stock market. This fear and concern is usually a good omen for the markets.

Intel disclosed a design error in a chip component that will cost the company about $300 million in lost sales, according to an Intel spokesman. ExxonMobil reported a 53% increase in quarterly profits, to $9 billion, its best numbers since Q3 2008.

Egypt is in the middle of determining a new direction. How the U.S. responds, and which leaders the U.S. supports, can have an impact on the outcome of these decisions. It can also impact the stability of the Middle East, and the safety of millions. President Carter chose not to throw the full weight of American opinion behind the Shah of Iran. The results over the last thirty years haven’t been pleasant. Are we taking the same approach now, with Mubarak?

The official unemployment rate fell to 9% in January, a 21 month low, though just 36,000 non-farm jobs were added. Consumer spending increased in December by 0.7%, and factory orders were up 0.2%. According to the ISM, the manufacturing reading stood at 60.4, and the service sector figure stood at 59.4, both at their highest in more than six years.

According to a recent AARP article, the five states with the biggest budget shortfalls for FY2011 were Nevada, Illinois, New Jersey, Arizona, and Maine. Alaska, Arkansas, Montana, and North Dakota were in the black.

Quote of the week: 

“Character is the ability to carry out a good resolution long after the mood in which it was made has left you.”
                                                                               Cavett Robert