The stock market pulled back during the second quarter but the decline was modest (3.1%)[i]. More than 100% of the decline was in May, as a disappointing jobs report threw cold water on hopes of an economic recovery. Stocks staged a modest rally in June on the hopes that the Federal Reserve would soon move to stimulate the economy (as it has done the previous two summers). While a slow growing economy does not necessarily imply a weak stock market, investors do need to believe that the economy’s trajectory is upward. Right now that confidence is fragile. Bulls are basing their case on the fact that corporate earnings continue to grow and profit margins are very high. The bear case is that we are slipping back into recession and when we do, neither earnings nor margins will hold up.
Because once again bonds outperformed stocks, I’m going to discuss their performance first. As the economy faltered, interest rates declined. This sparked a 2.1% gain in bonds for the quarter[ii]. In contrast to the first quarter, higher quality bonds outperformed more risk areas of the bond market. High yield bonds gained only 1.8% and emerging market debt 1.4%[iii]. The best performance came from those areas where duration is typically longer, such as TIPs and municipal bonds.
It was a disappointing quarter for those who believe inflation is a near and present danger. As interest rates fell, everything associated with the notion of inflation hedge (other than TIPs) declined as well. Precious metals and energy were the worst performing sectors of the market. Other sectors that depend on economic strength (materials, financials, technology, industrials, and consumer durables) also declined. The winners were the defensive sectors (utilities, health care, and consumer staples). Larger companies (-2.8%) managed to lose a little less than smaller companies (-3.6%); oddly enough mid-size firms did worse than either (-4.9%)[iv].
Not surprisingly, international stocks fared worse. For the most part, foreign economies slowed faster and their currencies depreciated against the dollar. The major foreign stock index, EAFE, declined -7.1%. Latin America fell the most (-13.2%). Asian stocks (ex-Japan) lost only -6.2%. Emerging markets stocks as a whole lost -8.9%[v].
We did not have to do much during the quarter because the portfolios had already been positioned for a weaker investment scenario. As a result, our risk-adjusted relative returns were very competitive. We have tried to be careful about owning volatile funds, even those with good track records, because we regard the chance of a 20% decline in stocks being greater in the short term than a 20% gain. We pride ourselves on being stubborn about giving back gains.
We believe that economic growth during this economic cycle is going to be considerably less than in previous cycles for a variety of reasons. This would suggest that stocks do not offer exciting return potential. That said, in an environment where bond yields are below 2% (for the most part) and inflation (outside of health care and college tuition) is barely above 1%, even mid-single digit stock returns would be attractive. This is driving the current mania for income- oriented sectors such as utilities, REITs, pipeline MLPs, and preferred stocks (they yield 4% or more, so they would beat most bonds without any change in price).
Bonds, on the other hand, often do quite well in the middle of the year. If there is less economic activity, for whatever reason, high quality bonds are probably going to benefit. High quality bonds have outperformed stocks over the last five years by an average of 6.74% per year[vi]! As a result, bond valuations are beginning to appear excessive in some areas. Many bonds are now priced above 100, which is the par value at which they will mature. In a time of market stress safe assets often get overvalued and risk assets get undervalued. At some point, however, the whole notion that bonds = safe, stocks = risky may have to be re-examined.
Commentary – The Event Uncertainty Principal
Last quarter I wrote about the three ways an advisor can add value. Two involved essentially timing decisions (buying when stocks were out of favor and consequently priced low; selling when stocks were in favor and consequently priced high), and one involved security selection. The problem with these value adding strategies is that at any given time there may not be anything you can do to implement them. For example, right now it is not clear whether or not stocks are particularly cheap or expensive. From a cyclical standpoint, most economists believe that the current economic expansion started in 2009. It seemed to stall in both 2010 and 2011, only to recover modestly with help from the Federal Reserve. It seems to be stalling again. Does that mean we have yet to see the cyclical peak, or has it already occurred?
In the absence of truly great buying or selling opportunities, and assuming we can’t identify the next Apple Computer (circa 2003), or the next buy-and-hold-for-the-next-decade sector like gold in 2001, what should we be doing? My close-to- three-decades in this industry have taught me that some of the best investment decisions are the ones where you elect to stand pat. Opportunities will present themselves if you are patient.
Perhaps human beings are tinkerers by nature – I certainly think most investment managers are. It is our nature to want to make each portfolio just a little bit better. We scrutinize a variety of measures to enhance the probability that we have the best fund or the best portfolio for a given scenario, but we know that it is just an educated guess – there will always have been something better we could have owned. It takes a certain amount of hubris for a manager to believe he or she can put together an “optimum” portfolio. That leads one to false confidence or endless tinkering – either of which, statistically, do not improve results.
During bull markets, it is usually a profitable strategy to identify the strongest stocks and/or strongest industry sectors and overweight them while owning little or nothing in the weakest areas of the market. This works because during bull markets trends tend to be long-lived (hence the cliché, “the trend is your friend”). However, during bear markets (and this current period is most likely a bear market despite the occasional strong rally), chasing trends usually does not pay off. There is no solid sector leadership, so by the time an outperforming sector is identified, it falters. This has really affected mutual funds that depend on momentum strategies, as well as most alternative strategies. When a strategy that had been working stops being effective (and this happens to EVERY strategy at some point) rather than reflexively chasing what is currently working, the wise advisor steps back and assesses why the strategy is no longer effective and what that tells him about the current environment.
The Event Uncertainty Principle is based on the premise that NOBODY knows what the market is going to do in the short run. There are two kinds of mistakes that investors make – being wrong and being early. If you absolutely knew what was going to happen and precisely when (and everybody else did not have this information), you could make a very large amount of money. Even the biggest and most well-connected don’t know what is going to happen and when. Otherwise J.P. Morgan would not have lost several billion dollars on one trade recently, and Bear Stearns and Lehman Brothers would still be with us.
When something happens we have a tendency to say “of course that happened. It was obvious that was going to happen”. When we think about the sub-prime debacle, for instance, it seems obvious now that those mortgages should not have been rated AAA. At the time, however, that was a radical notion. Even those who knew there was a problem did not necessarily get the timing right. It is just human nature to try and make sense of things, and in doing so establish the world as a more stable, orderly, and predictable place than it really is. The randomness of life can be unsettling.
The bottom line for us is to deliver the best investment results we can. The point of this Commentary was to establish that it isn’t always clear what will produce the best results in the short term because even widely-predicted events tend to unfold in an unpredictable manner. While the future is always uncertain (no matter what people tell you) that doesn’t mean that very good opportunities don’t arise from time to time. We just don’t believe we are in such a time right now. Valuations do not scream either buy or sell. The economy is not obviously growing nor is it clearly contracting. The macro environment may seem scary, but that did not stop stocks from gaining more than 9% in the first half of the year. In this environment, we aren’t inclined to be very active because we are skeptical that doing so would add much value. Be assured, however, that should any of these conditions change, we are ready to pounce on the opportunities they create.
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[i] Wilshire 5000, per Morningstar
[ii] Barclay’s Capital Aggregate Bond, per Morningstar
[iii] Barclay’s Capital High Yield Corporate Bond and Barclay’s Capital Emerging Market Debt, respectively
[iv] Standard & Poors 500 (Large Cap), 600 (Small Cap), and 400 (Mid Cap) Averages, respectively
[v] MSCI EAFE, Latin America, Asia ex-Japan, and Emerging Markets, respectively, net return in dollars
[vi] As of July 20, 2012 Vanguard Total Bond Index has a 5 year annualized return of 6.89%. Vanguard Total Stock Index is up 0.15% over the same time frame (per Morningstar).