Once again, most of what could go wrong for the global economy did not go wrong. Investors began to accept the idea of a U.S. led expansion and pushed stocks to levels not seen since early 2008. What began last October as a relief rally based on the premise that the global economy was not about to crash has turned into genuine optimism. Unemployment continued to decline (though not as fast as we’d like), bond yields remained low, the Federal Reserve remained accommodative, and the European Central Bank kept the Eurozone from collapsing. I’m not sure this merited a second consecutive 12% quarterly increase in stock prices, but I will gladly take it[i].
Unlike last year when stock performance varied wildly (U.S. stocks averaged a slight gain while foreign stocks plunged over 12%)[ii], this past quarter saw fairly uniform gains. The S&P 500 index gained 12.6% while small stocks, as measured by the Russell 2000, rose 12.4%. The real difference in performance came from the industry group. Financial services stocks rebounded strongly last quarter (22.3%)[iii] after being the worst performing sector last year and over the previous 5 and 10 year periods. Technology also performed well (21.7%)[iv] led by a 48% gain in Apple, Inc[v]. Given the spike in gasoline prices, Energy was a surprising laggard (4.9%)[vi]. Natural gas prices have plunged as improved drilling techniques and an unusually warm winter have resulted in a supply glut. Utilities (-1.5%)[vii] was the only losing sector during the quarter. They had been bid to overly lofty levels last year by defensive and yield-hungry investors. For the quarter, growth stocks gained 16.7% while value stocks rose only 9.2%[viii]. This shows the preference investors now have for opportunity over relative safety.
Despite a fairly dicey global economic outlook, foreign stocks rose 10.9%[ix]. Emerging markets gained 14.1%[x]. One might have expected Europe to have been a laggard, but they still jumped 10.7%. Latin America was up 14.6% and the Asia-Pacific region 11.7%[xi]. Foreign stocks have performed much worse as a whole since 2008 and unlike U.S. averages are nowhere near their late 2007 peaks.
The best that can be said for the bond market is that yields did not spike as some predicted. Bonds recovered from two waves of interest rate jitters to finish with a slight gain on a benchmark basis (0.3%)[xii]. Fortunately, most traded bond funds are shorter in maturity and lower in credit quality than the benchmark, which allowed them to gain an average of 0.9%. High grade corporate bonds rose over 1%, while high yield corporates made more than 5% and emerging market bonds tacked on 5.5%. Global bond funds fell close to 1%.
As this quarter saw mostly a continuation of the dynamics of the previous quarter, we did not make many changes. Where we did, it tended to be to make sure the securities in aggressive portfolios were keeping up with the surge in financial services and technology. We increased the use of Touchstone Sands (PTSGX), a momentum-oriented large cap growth fund. The addition of Apple stock to aggressive portfolios last year has worked out very well. In more conservative portfolios we reduced both cash and global bond weightings in favor of U.S. corporate bonds. Global government bonds slumped in dollar terms as U.S. economic growth was much better than that of Europe or Japan. Our overall philosophy, which was to err on the side of caution by employing less aggressive, more dividend-oriented stock funds, remained in place for most investors.
There is much uncertainty out there. Political uncertainty in the U.S. driven by the Presidential election, economic uncertainty in Europe driven by the fact that many countries have debt burdens they cannot meet through growth or currency depreciation, and uncertainty in China driven both by political changes (a new group of leaders are elected by the Party this year) and economic challenges (how to rein in inflation without hurting the economy too much). There are very few potential upside catalysts on a six month basis. What we’ve achieved over the past few years has largely occurred through aggressive central bank (Federal Reserve and ECB) manipulation of credit and the bond market. That can’t continue forever.
The bottom line is this: Stocks are no longer cheap. Over the past three years stocks have been available at a discount. That seemed appropriate, as circumstances (a collapsed U.S. real estate market, high debt relative to GDP in most of the industrialized world, a potentially shrinking government sector) suggested that economic growth would be lower than average this economic cycle. Investors did not want to pay the average market multiple for stocks if profit growth was going to be below average. As it turned out, profit growth thus far has NOT been below average. There are a variety of explanations for this, but the bottom line is that corporate earnings have done better than expected, and investors have finally given in and re-priced stocks (upward). Today many stocks trade at prices that assume this robust profit growth will continue. When expectations are low, “risk” (the chance that the expectations are wrong) tends to be to the upside. Now that expectations are fairly high, in many areas there is more downside risk than upside. Take homebuilders, for example. After a 65%[xiii] six month gain the industry now trades at prices that assume a multi-year housing recovery. If that happens, those stocks have fairly modest further upside potential. If the recovery falters, they have double digit downside potential.
Commentary – How to Add Value
There are two basic ways an advisor adds value. One of them is to earn the client a greater return than the market provides at their level of risk tolerance. The other is to protect them from making decisions they will regret later. I’m well into my third decade as a money manager, and I can tell you with certainty that the latter is far more important.
There are three ways an advisor can improve investor return over the course of a market cycle:
- They can increase stock exposure when markets are near cyclical lows (buy low)
- They can decrease stock exposure when markets are near cyclical highs (sell high)
- They can own superior funds that either make more when the markets go up, lose less when markets go down, or a combination of both (security selection)
We have always paid special attention to security selection. We carefully examine past performance and attempt to determine what the factors were that led to superior results. More importantly, we want to know if those factors are still in place. Is the manager still there? Is the fund able to deal with the influx of new money? Are market conditions reasonably similar to those the manager has successfully navigated in the past?
We also try to buy low and sell high, but this is a lot more difficult. Markets are rarely at extremes. Most of the time valuation doesn’t provide much short-term guidance. Since you can never know exactly where the cyclical low is (until you have passed it), buying low requires a certain intestinal fortitude. It is fair to say that most people do not have it. Selling high is only modestly less difficult. Far fewer people call you in a buying panic in up markets, but occasionally they move their money. When the stock market really took off at the end of the 1990s, it was very difficult for anyone managing a diversified portfolio to keep up. Put simply, every dollar that you had in stocks that wasn’t in the technology sector cost you in performance, and it might get you fired. Nobody wanted small stocks, foreign stocks, or gold or energy or manufacturing stocks (unless they made computers). Most managers rode the tide, posting great numbers before the crash. Local money manager Lee Kopp had two years in the 1990s with returns of greater than 100%. Some managers resisted, and a few didn’t survive long enough to be proven right (anyone remember George Vanderheiden or Robert Sanborn?). As you know, the technology sector eventually crashed and the NASDAQ is still to this day more than 25% below its 2000 peak (while the non-technology sectors all made new all-time highs by the end of 2007). Kopp’s mutual fund lost so much money he closed it.
The point is that earning a greater return than the market for a while turned out to be far less significant for the client than keeping his portfolio diversified.
That said, in order for an advisor to add value for you there needs to be mutual trust The client has to trust that the advisor knows what he is doing when he’s not selling on down days (or God forbid if he’s buying!) or if he’s raising cash when markets are strong. The advisor has to trust that the client will not pull the plug on the strategy before it has a chance to work (because it will never work at first; you will never start buying on the very lowest day nor will you ever sell at the absolute top). Markets tops and bottoms are not one day events they are processes. Advisors’ strategies have to be processes as well. This means you have to start lightening up on stocks before you believe they have peaked. These are the times when you wish there were no benchmarks and no CNBC to make investors anxious. When investors should be thinking, “I’ve made a bunch of money but prices are kind of high now. I should maybe take some profits”, instead they say “How come I didn’t make as much as the Dow did?”
With the advent of exchange traded funds, matching a benchmark is easy. The question is whether or not matching the market’s fluctuations is the best way to reach your goals. Hopefully you know by now that we place a high value on minimizing losses. A quick glimpse of this chart shows why. Note how much harder it is to make up a 25% loss than a 15% loss. The S&P 500 plunged approximately 56% from October 9, 2007 to March 9, 2009. Though it has more than doubled from its low, it has not yet made up that loss. If one had lost only 35% during the last bear market, and then earned just half of the market’s 112% subsequent gain (through 4/14/12), he would have more than recovered his loss. We all want to capture 100% (or more) of the market upside, yet experience substantially less of its downside. That is not possible without being willing to give up some upside as markets approach the top of the cycle. Great investors do not try to maximize gains in every environment any more than great golfers always aim for the pin. To do well, you have to calculate the risk and reward potential and decide what kind of approach the circumstances warrant. Right now we believe the answer is “Cautious”.
The following shows that if one were to lose -20% and then gain back +20%, one would still be short 4%. The investor would need a 25% gain to make up for a 20% loss. If he lost twice as much (-40%), a subsequent gain of +40% leaves him not 8% but 16% short. He needs a 66.67% gain to get back to even.
Loss And Recovery Table
As much as you want your advisor to out-perform every quarter, what you really need him to do is protect you from surrendering to greed or fear. You want him to exercise judgment such that you can experience as much of the upside as your risk tolerance permits, be that 30% or 100%. You need him to be calm in both soaring and diving markets, because that is where large sums of money are ultimately lost or made. We are up to the challenge. We have demonstrated the patience and the nerve to sell early and buy early. Today, we believe we are in a “sell early” situation where it makes sense to dial back on risk before the next crisis is upon us. We thank you for your trust in allowing us to do this for you.
Past Performance is no assurance of future results
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[i] The S&P 500 was up 12.59% during the period 1/1/12 – 3/31/12. It gained 11.82% from 10/1/11 through 12/31/11.
[ii] The MSCI EAFE (Europe, Asia, Far East) Index declined 12.14% in 2011.
[iii] Morningstar Financial Services Index
[iv] Morningstar Technology Index
[v] Based on the 3/31/2012 closing price of $599.55 and the 12/31/2011 closing price of $405.00.
[vi] Morningstar Energy Index
[vii]Morningstar Utilities Index
[viii] Morningstar Growth and Value Indices
[ix] MSCI EAFE Index, Net Return in Dollars
[x] MSCI Emerging Market Index, Net Return in Dollars
[xi] MSCI Europe and MSCI Asia-Pacific Indices, Net Return in Dollars
[xii] Barclay’s Capital Aggregate Bond Index. All other bond indices cited are also from Barclay’s Capital.
[xiii] Per Telemet, the XHB Homebuilders ETF has gained more than 65% from its 10/3/2011 low.