As is so often the case with stocks, a very bad quarter was followed by a very good one. Last quarter the stock market rose close to +12%, not quite erasing the previous quarter’s -15% loss but putting U.S. stocks ever so slightly into positive territory for the full year[i]. The biggest reason for the strong stock performance last quarter was that last August and September investors discounted stocks to factor in the risk of a European economic collapse and a slide back into recession here in the U.S., but when neither occurred investors re-priced stocks higher. The bears apparently did not count on the ability of world bankers to once again find a way to put off the day of financial reckoning. It is not as if the situation in Greece or Portugal has gotten any better; markets have just stopped worrying about it for the time being. Call it “gloom fatigue”.
Almost every asset class gained. Stocks gained because the global economy managed to muddle along despite investors fearing much worse. Bonds rose because economic performance was weak enough to allow interest rates to fall further. Only gold managed an outright decline (-3.84%)[ii]. Transportation stocks did the best (+20.37%)[iii] as the economy rebounded somewhat while fuel prices declined. Small company shares surged +17.17%, but like large caps they failed to fully recover from their huge (-19.83%) third quarter decline[iv]. Investors tended to favor utility, health care, and consumer staples companies for their ability to withstand an economic downturn. Financial and materials stocks performed the worst.
International stocks rose, but very modestly. While U.S. stocks were able to erase more than 80% of their 3Q11 losses, overseas companies only recovered about 20% in dollar terms. Bond guru Bill Gross coined the phrase “cleanest dirty shirt” to illustrate the fact that while the U.S. financial struggles are considerable, everyone else’s seem worse. Overall, foreign stocks gained just +3.33% last quarter to finish the year down -12.14%[v]. India and Latin America performed even worse than Europe last year.
Bonds (+1.12%)[vi] recovered from a fear induced sell-off in the third quarter that saw only highly rated bonds post gains. World central banks’ efforts to boost liquidity especially helped riskier sovereign debt and high yield corporate bonds. Municipal bonds continued their strong recovery from the panic selling that followed Meredith Whitney’s December 2010 appearance on CBS’ 60 Minutes program. Their +10.7%[vii] gain for the year was second only to long term Treasury Bonds. Playing it safe was not the way to go as money market yields were essentially zero.
It was not a very active quarter compared to other recent quarters. Funds that favored more defensive industries tended to perform better from the beginning of May to the end of the year. We had already made those changes over the summer. The international component of portfolios was a bigger challenge. The best performers for most of the year were those that owned some gold as a hedge, but that changed dramatically in the fourth quarter. At that point we moved to foreign funds that hedged currency exposure, favored defensive industries, or had some U.S. exposure. On the bond side, we had to replace funds where the fund managers had shortened duration too much, because we wanted more interest rate exposure in order to benefit from falling rates.
I would like to be able to say that the rally last quarter proves the naysayers are wrong and that we no longer have to fear an economic slowdown or a crisis triggered by Europe or China, but I can’t. Those risks are still there. While some of the weakest sectors from last year (financial services, materials) are having a nice bounce in 2012, I am not ready to change our portfolios. For most investors we are going to continue to err on the side of caution.
If you recall, last quarter I wrote that at some point stocks get so cheap that you just have to “hold your nose and buy”. Three months and +15 percent later, we are closer to the other end of the spectrum. We are not at valuations that suggest that a 2008-style 50%+ decline is in the offing, but if the crisis in Europe leads to a global recession, a 2002-type 20-30% sell-off would not be a great shock. That said, I don’t believe a decline is imminent. In the short term, things look fairly good. The economy is growing and corporate profits continue to rise. We can’t run our financial lives worrying about the bad things that might happen, but we do have keep the risks in mind. In our case, this means being on the more conservative side of our asset class ranges, and using alternative strategies to substitute for stocks, bonds, and cash where appropriate.
Commentary – The Trouble with Benchmarks
One of the things all advisors tend to struggle with is benchmarks. In other words, how do we help a client evaluate whether or not we’ve done a good job? For a long time we used a market benchmark like the S&P 500 or the Dow Jones Industrial Average, because we knew these were indices that could be easily obtained and that our clients were familiar with them. For many moderate risk investors these indices never made sense, however, because our clients were not 100% invested in large U.S. companies like those indices are. We have diversified our clients’ portfolios with small companies, foreign stocks, bonds, money market funds, and maybe even a little gold. Therefore it made more sense to use blended benchmarks, which combine most or all of those asset classes. This is an improvement, but there are still certain shortcomings that are present no matter what kind of benchmark one uses. One, fear of underperforming a benchmark can lead advisors to think short term and make decisions that ultimately cost investors; and two, any benchmark is only as good as its components.
Let’s look at how good our benchmarks are. Is the Dow Jones Industrial Average a good benchmark for the stock market? It’s a price-weighted index, meaning that the highest priced stock (IBM) has a much greater impact than does Exxon Mobil, despite the fact that the latter is nearly twice as large by market capitalization (number of shares outstanding multiplied by the price per share). If price-weighting was the best measure of value, Bank of America could do a 30-1 reverse split and go from 30th in importance in the Dow to first, even though the split wouldn’t have made its shareholders a single penny. While the market cap-weighted S&P 500 has done a pretty good job reflecting the value of the average stock over time, its performance can be skewed by erratic investor behavior. The incredible rise and fall of technology stocks from 1997 through 2002 led benchmark investors on quite a wild ride. Because of this, other firms (most notably Research Affiliates) have come up with alternative benchmarks which employ such strategies as equal-weighting or fundamental weighting (weighting companies based on metrics such as revenue or book value).
Other asset classes also have problems with benchmarks. The most popular bond index (Barclay’s Aggregate Bond Index) has a much longer maturity and high credit quality than the average bond fund, making it incredibly hard to beat when interest rates fall and surprisingly easy to beat during economic recoveries. The most popular international index (Morgan Stanley’s Europe, Asia and Far East Index or MSCI EAFE) has been an easy bogey for most of the top foreign fund managers due to its high relative weighting in Japanese stocks. So the question is, should advisors follow benchmarks whose composition is arbitrary or which might cause investor portfolios to be unnecessarily volatile?
A better question might be whether advisors should follow benchmarks at all. One study[viii] concluded that the less a fund manager clung to his benchmark the better he tended to do. This fits with what we have observed over our many years in the business. Let’s go back to 2008. The S&P 500 plunged -37%; foreign stocks dropped more than -45%. It would have been hard to underperform any stock index that year with a properly diversified portfolio, so most advisors did a good job, right? It is doubtful, however, that many of them felt good about the year. I know I didn’t. To have done well in a bad year from a client standpoint, advisors had to step outside the benchmark way of thinking.
People have finite lives. They can’t always rely on what stocks will do in the long run. They have a fixed number of earning years and then they have to live on what they have saved. Most people cannot endure another -25% or -30% year even if the market loses -60%. So to some extent advisors need to move from relative return (how did client portfolios perform relative to the appropriate benchmark) to absolute return (how much did client portfolios make or lose). We need to be able to position your portfolios to grow within the risk parameters you have given us regardless of what the market is doing, and we will only do this well if we don’t fear that we are being judged on every quarter’s performance relative to the benchmark.
The way markets move today would you even want to try to chase it? Let’s look at the last six weeks. At the beginning of December investors were feeling a little shell-shocked. The stock market had already posted 35 trading days in 2011 with gains or losses of more than +/-2% (I believe in 2006 there were zero). The prevailing sentiment was to pile into the least volatile, highest yielding stocks and hope to finish the year with any kind of a gain. Investors drove telecom stocks, utilities, health care stocks and consumer staples up another +3 to +4%. On the other hand, technology and materials extended their year-to-date losses as investors sold those stocks for tax purposes. Fast forward to the first half of January 2012 and the top sector is materials and the worst is utilities. One moment investors are motivated by fear, the next by greed. Next week it’ll probably be fear again. As a financial professional I can’t manage to a benchmark when the market’s mood shifts from ebullient to despondent and back more often than:
- Lady Gaga changes outfits
- The Vikings change new stadium locations
- <Insert your least favorite politician> changes their mind
Kidding aside, what we are saying is that benchmarks have their uses but please do not get too hung up on them. Your financial planner has provided us with your risk tolerance and we manage your portfolio consistent with that mandate. We will continue to make buy and sell decisions in your portfolios based on our perception of each security’s risk and reward potential, as opposed to what the market is currently doing. We give you information each quarter which includes benchmarks because we want you to have an idea of what we had to work with in terms of the opportunity to grow your portfolio. Beyond that, benchmarks have some serious flaws in terms of assessing both what a client should expect to have made in a given period, and the value an advisor provided (especially in the short term).
Past Performance is no assurance of future results
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[i] As measured by the S&P 500 all performance information in this section is taken from Morningstar.
[ii] As measured by GLD
[iii] As measured by Dow Jones Transportation Index
[iv] As measured by the S&P 600 Small Cap Index
[v] As measured by the MSCI EAFE
[vi] As measured by the Barclay’s Aggregate Bond Index
[vii] As measured by the Barclay’s Capital Municipal Bond Index
[viii] K.J. Martin Cremers and Antti Petajisto, “How Active is Your Fund Manager A New Measure That Predicts Performance,” Yale School of Management, March 31, 2009.