Wednesday, April 20, 2011

Q1 2011 Investment Commentary

STOCKS CONTINUED their upward march in the first quarter, with large-caps gaining almost 6%, while mid- and small-cap stocks posted gains approaching 8% (see table on back cover for index returns). Overseas, returns were not as strong, though still good. Developed-market foreign stocks were up more than 3%, while emerging-market equities gained just under 2% for the quarter. Domestic high-quality intermediate-term bonds didn’t fare as well, barely gaining ground in the first quarter, while foreign bonds did a bit better, with developed-market government bonds gaining 0.7% and emerging-market bonds climbing by almost 3%.

We Are Not Perma-Bears, But We Are Cautious Now

For various stretches over the last 13 years we have been cautious towards the stock market based on our assessment of market valuations and expected returns. This has frustrated our clients at times, the late 1990s being the most notable example, as the S&P and Nasdaq rocketed higher during the late stages of the tech bubble. We wrote about our market concerns at that time, and our caution proved to be warranted. Despite another bear market in 2008, all of our portfolio models outperformed their benchmarks during this period, though there were a couple of performance slumps along the way—notably in 1998 and 2008.

As we reflect back and look forward, there are several points worth emphasizing.

1. Our valuation-driven, scenario-based approach is designed to help us make good decisions over the long-term. We know we can’t predict the short-term with consistent accuracy.

2. Even in the midst of long periods where returns are low there are still opportunities. In fact, these low-return periods are often characterized by higher volatility that can offer occasional fat pitches in “risky” asset classes like equities, REITs, and high-yield bonds.

3. We are not perma-bears. There have been extended periods over the past decade where our equity exposure was at a neutral level and/or our actual “equity like” exposure was at or above neutral (taking into account exposure to asset classes that have some equity-like risk such as high-yield bonds and REITs).

Currently, we are positioned somewhat conservatively with our portfolio allocations, and there are a few important points to make in this regard.

First, our longer-term analysis suggests that stock returns are likely to be mediocre over our five-year time frame–most likely somewhere in the low-single-digit range. We analyze return ranges for stocks by considering the possible economic scenarios we could see, and then considering how the “building blocks” of equity returns—dividends, earnings growth, and multiples— stack up under each. A challenge is that the range of possible outcomes is unusually wide, ranging from another re-cession to a return to the “old normal” patterns of borrowing and spending. We believe the odds skew towards the more negative outcomes, and this impacts how we want to allocate our portfolios.

Second, likely returns from bonds are even lower than stocks. With interest rates quite low, and longer-term inflationary pressure likely to result from our government’s fiscal policies and challenges, it is far more likely that we will see rising rates (which push bond prices lower) than falling rates over our investment horizon. Without the tailwind of falling rates, and with yields on bonds starting at low levels, we expect only very low single-digit returns from core high-quality bonds. Ordinarily, if we believe equity returns are likely to be higher than bonds, it would argue for being fully weighted to equities to capture that higher return.

That brings us to our third point, which is that with low expected returns for stocks and bonds, and with significant big-picture risks out there that could damage returns (especially in the shorter-term), we are underweighted to both stocks and core bonds in our balanced portfolios in favor of invest-ments that we think collectively offer better or at least competitive returns at less risk.

Examples of portfolio positions that we believe offer a better risk-reward tradeoff include: short-term high-yield bonds that offer better yields but generally low default risk thanks to their short ma-turities and careful credit research (Osterweis Strategic Income); flexible, absolute-return-oriented bond funds that have a broad toolkit with respect to the types of bonds they can own and their ability to limit the risk of rising rates (PIMCO Unconstrained); floating rate funds that generate good yields but that are not exposed to the risk of rising rates, and arbitrage strategies that are able to earn a return without the tailwind of rising stock prices.

These investments are generally a little riskier than core bonds in that they would provide less pro-tection from a severe downside scenario such as recession or deflation, but they are significantly less risky than equities. Since these positions are funded from reductions in both stocks and bonds, the net effect of these positions is to reduce overall portfolio risk while generating as good or better re-turns in most scenarios.

We have two other fixed-income investments that come with a notch-higher risk than the invest-ments described above, but that similarly offer better bang for our risk buck. The multi-sector Loomis Sayles Bond invests in (among other things) carefully selected high-yield bonds and foreign bonds, mainly of commodity producing countries, which provides some hedge against a falling dollar. The other fund—PIMCO Emerging Local Bond—invests in the bonds of emerging-markets countries and is a more direct-dollar hedge. It offers an attractive 7% yield and the chance for greater currency appreciation if our longer-term assumptions that the dollar will decline prove correct.

Our core investment-grade bond exposure is achieved mostly via PIMCO Total Return and munici-pal bond funds for taxable portfolios. Given the media focus on state and municipal finances, we want to share briefly our view on municipal bonds.

For taxable portfolios, municipal bonds are still a core position. This sector of the bond market has been in the headlines for months with some commentators making doomsday forecasts of massive defaults. This asset class is hard to evaluate on an aggregate basis because of the lack of underlying fundamental data and the fact that there are about 60,000 different bond issuers. We’ve approached our analysis by talking to and reading the analysis of experts in our network, reviewing research and data, and studying the structural factors that affect the finances of different types of muni issuers. We believe the massive default forecasts are greatly exaggerated. While defaults are almost certain to increase among smaller local issuers and will likely be higher than in past cycles, we believe there are plenty of solid muni credits available to bond managers.

Scattered high-profile defaults are entirely possible and these could spook investors and trigger more temporary nasty sell-offs for the broader municipal bond market, so we expect higher volatility than taxable investment-grade bonds. But the overall market is currently pricing in a default level that we believe is much too pessimistic—many muni bonds are offering tax-free yields that are higher than taxable U.S. Treasury yields. If municipal yields relative to taxable bond yields normalize over five years (the muni yields normally are lower since they are exempt from tax), investors may be able to capture returns that are nearly as high as the current yields, even in light of the rise we expect in the general level of interest rates. This should equate to pre-tax equivalent returns of around 5%, much better than the returns we expect from taxable investment-grade bonds. This makes municipal bond funds a decent asset class to own for the conservative portion of our portfolios for those who can ac-cept the higher shorter-term volatility.

The final point we would make about our conservative positioning is that if we continue to see strong stock returns, it is likely our portfolios will lag their benchmarks. And while we did manage to outperform in 2010 despite a sharply rising stock market, we trailed in the very strong fourth quarter and again in the first quarter of this year. It may seem odd to be cautioning clients about the “risk” of stocks continuing to march higher, but it is worth considering what that risk really is. The risk is that rising markets leave investors feeling that they missed the boat, which leads them to increase their equity exposure at a time when high stock market valuations offer less longer-term return potential and greater vulnerability to a correction.

We are often asked: “What if you are wrong and stocks just keep going up”? Stocks can keep going up in the shorter-term, and this is not something we are confident in our ability to predict. But over the longer-term, which we can analyze with more confidence, an important driver of stock returns will be earnings growth, and this is highly correlated to the overall economy. So could the economy perform well enough to continue to drive the kinds of stock returns we’ve been seeing? Consumers could ramp up spending, and take on more debt, and the jobs and housing pictures could improve more quickly than we expect. But even if that happens to some degree, the deepest underlying prob-lems aren’t going to go away as a result.

The deeper problem is that we have gone through a massive build-up of debt that occurred over many decades, and a lot of it still remains. Some of it has effectively been shifted to the government. With large deficits, a growing national debt, and entitlement spending on track to make these prob-lems significantly worse over coming years and decades, it is inevitable that at some point as a nation we will have to take our medicine. When we do, it will mean we borrow less and spend less, which will reduce economic growth, and that will be a drag on corporate earnings and therefore stock returns.

It is in considering the headwinds the economy faces in the years ahead, and factoring in other big-picture risks such as Europe’s debt problems, unrest in the Middle East, Japan’s disaster, and other possible shocks we can’t foresee, that we conclude that the returns stocks are likely to earn aren’t sufficient to compensate us for taking on the risk. We’ve often said that we view investing as a ma-rathon, not a sprint. We all are investors over a lifetime and any one year is a small slice of our in-vestment timeline. Over our investing lives there will be periods when it pays to be conservative and others when it makes sense to be aggressive. Sometimes these periods will be short, others times they will last for years. Along the way there will be ups and downs within each of these periods. Our challenge is to ignore the ups and downs and focus on the potential returns we believe we can cap-ture and weigh them against the risks.

Ultimately, what drives our risk-taking is the presence of a margin of safety, i.e., a significantly un-dervalued asset, such that even in a bad scenario it shouldn’t have much downside. Today we be-lieve there is an inadequate margin of safety in the stock market. Valuations are not attractive enough to compensate for the many serious concerns we’ve mentioned that could impact investment funda-mentals. And because we have other investments that can generate competitive returns at less overall risk, we are not concerned that over the longer-term we are giving up a lot of opportunity even if we see a scenario that is better than we expect.

Meanwhile, it is worth noting that despite our significant equity underweight, our net “risk un-derweight” is less than it seems because many of the investments described carry higher risk than bonds, from which they are partly funded.

Two final points about return expectations are that the equity managers we own can boost returns through outperformance, and many are indicating that at the stock-picking level they are finding good opportunities. Additionally, we are confident that inevitable periods of fear will drive certain asset classes lower and present us with opportunities to earn much more compelling returns in exchange for ratcheting our risk higher. This discipline and longer-term focus, along with careful underlying research, is the core of what we bring to the table as investment advisors.– Centurion Advisory Group Research Team (4/11/11)

Thursday, April 14, 2011

Makers vs Takers

THE WEEK WAS FLAT ON THE DOMESTIC EQUITY side. By the numbers, for the week ended Friday, April 8, 2011, the Dow Jones Industrial Average closed at 12,380, up 4 points, representing almost no change from the previous week. The Standard & Poor’s 500 closed at 1328, down 4 points, and the NASDAQ Composite closed at 2780, down 9 points.

Politicians came to an agreement late Friday evening that avoided shutting down the government. Each side trumpeted the success of favorite programs, or the saving of what’s been described as $39 billion. If these decisions didn’t weigh so heavily on the future of our country, at least the posturing and grandstanding of Congress would provide a bit of comic relief.

This continuing uncertainty, both at home and abroad, sent gold to new highs, and oil to new highs for the year. In the last couple of days, however, fear and profit taking have sent the market down 2% and change.

Kerri Shannon, writing for Seeking Alpha, has suggested a real inflation rate of 9% to 12%, compared to the 3% or less suggested by the feds. Gasoline prices are up 19% over the last year, and the producer price index was up 1.6% in February, double the January increase and more than twice the expected 0.7%.

Wholesale food prices were up 3.9% in February, the largest monthly increase since November 1974, and up 7.3% in the last twelve months. Given these increases, it will be tough for retailers not to raise prices, as they have been absorbing most price increases so far.

Stephen Moore, writing in the Wall Street Journal, offers insight into why so many states are operating at or near bankruptcy. According to Moore, there are 22.5 million government employees, and 11.5 million manufacturing employees. In 1960, manufacturing employed 15 million, and government 8.7 million.

“More Americans work for the government than work in construction, farming, fishing, forestry, manufacturing, mining, and utilities combined. We have moved decisively from a nation of makers to a nation of takers”, says Moore.

The future? Surveys of college graduates are finding that more and more of our top minds want to work for the government. In recent years only government agencies have been hiring, and government employment offers near lifetime security in this era of economic turbulence.

In economic news, the Institute for Supply Management’s service sector index dropped in March to 57.3 from 59.7. Any number above 50 is a positive, though this change indicates a slowdown. Initial jobless claims dropped to 382,000 last week, and consumer credit increased in February by $7.6 billion.

According to a very unofficial survey of several mortgage brokers, business is booming in terms of new loan applications. A larger number of these loans won’t be placed compared to three or four years ago, due to actual underwriting, but the activity is encouraging. Apparently, the buyers are those who are taking advantage of foreclosures and lower prices to become homeowners.

Quotes of the week:

“Unforgiveness is like drinking poison, in the hopes that someone else will die.”

“When the people find that they can vote themselves money, that will herald the end of the Republic.”
                                                                                         -Benjamin Franklin

Thursday, April 7, 2011

Capital - Human, Shared, Financial

IN SPITE OF UNCERTAINTY AROUND the world, the domestic equity indices have turned in a solid performance the last two weeks. By the numbers, for the two weeks ended Friday, April 1, 2011, the Dow Jones Industrial Average closed at 12,376, up 518 points, or 4.2%. The Standard & Poor’s 500 closed at 1332, up 53 points, or 4%, and the NASDAQ Composite closed at 2789, up 146 points, or 5.2%.
For the first quarter of 2011, the Dow gained 6.4%. This put the quarter’s return in the 70th percentile of returns over the last 120 years, and represents an annualized return of more than 28%.

Non-farm payrolls grew by an adjusted 216,000 in March, the best growth since May of 2010. This puts the official unemployment rate at 8.8%, though we suspect that the unofficial unemployment and underemployment rate is closer to 20%.

David Sokol has left Berkshire, presumably to run the Sokol family office. Maybe he should have had a V8, instead of buying Lubrizol for his own account first.

Home prices in 20 major U.S. markets fell 1% in January, according to Case-Schiller, the sixth consecutive monthly decline. Only Washington, D.C. saw an increase in home prices. At least someone is benefiting from our grandchildren’s tax money.

In other economic news, consumer spending was up 0.7% in February, though consumer confidence dropped. Factory orders and manufacturing growth, as well as public and private construction spending, fell in February.

As noted more than once in this space, we continue to have concerns about domestic and international equity markets. Sovereign debt, both domestically and around the world, combined with the plantation mentality that seems so prevalent, doesn’t bode well for strong growing economies, and the consumers and companies that participate in those economies.

Financial planning as a discipline has, for about twenty five years, centered on financial analysis and investment management. The missing links for many have been the coordination of these number crunching exercises with a client’s work life, which we can call human capital, as well as the client’s choice to give back, which we can call shared capital.

Would it help to engage in a way such that financial analysis and investment management was integrated with how you engaged with work and business, as well as your vision of how you wanted to make an impact? Let us know. We are exploring this question internally at the moment, and would appreciate any feedback you care to share.

Pain is a gift. It lets us know something is wrong, and that it’s time to pay attention. What if the nerve endings in your fingers were gone? You could pick up a hot skillet from the stove, but would lose your hand at some point, due to burn damage. More on this topic later.

Quote of the week:

“Being unwanted, unloved, uncared for, forgotten by everybody, I think that is a much greater hunger, a much greater poverty, than the person who has nothing to eat.”
                                                                                                       Mother Teresa