Thoughts on Equities
We seldom get through a year without at least one down quarter, but we are presently on a six quarter winning streak (if measured by the S&P 500 – see Figure 1). Despite last week’s sell-off, that index is on pace to extend the streak to seven. Measured by almost anything else, however, the quarter has been lousy. Small company stocks are down almost -6%. Foreign stocks are down -5.3%. The average stock on the NYSE is off -2.3%. Commodities such as gold, oil, and real estate are down. Bonds are just above break-even on the whole, but the more opportunistic sectors (foreign and high yield bonds) are each off quite a bit.
Of course the temptation is to go to where the money is flowing. As the going has become tougher, many of the tough have thrown up their hands and indexed their portfolios to the S&P 500 stock index. When you are in the middle stage (by far the longest, time-wise) of a bull market, indexing tends to out-perform. This is because 70%-90% of stocks and industries are rising, so it pays to be fully invested and added risk is generally rewarded. When the bull market gets into the final stage, however, the number of strong performing stocks and industries tends to narrows. Whatever is still doing well attracts more and more money, and reaches ever higher prices. Therein lies the problem of indexing, it forces you to buy stocks that are rising and sell stocks that are falling. Think of the energy sector in 2007-8. As the economy began to overheat, the Fed hiked interest rates which choked off most of the market. Energy stocks were thought to be immune since we needed more energy than we could produce. Investors flocked to oil, which spiked to $147/barrel in June. At that price, oil demand was less than supply. Speculators panicked and oil went into free fall, eventually bottoming at $32/barrel. The S&P 500, dragged down by its energy component, actually underperformed mid- and small cap stocks in 2008.
Large company stocks appear to be the safe haven of choice today, with the health care and technology sectors leading the way. We have participated in this by increasing the average capitalization of our portfolios and by including a health care sector fund in all but conservative portfolios. We are concerned, however, that the bull market is becoming too narrow to be sustained. Energy stocks have fallen sharply this quarter. Utilities, Real Estate, Metals, Housing, Media, and Financials are all off more than -2% this quarter. The remaining areas of strength probably cannot accommodate the flows from the increasing number of weak performing sectors. An overall stock market “correction” seems likely.
It would be foolish to try to predict when the correction will begin or what the magnitude will be, but most of the time they do not exceed 20%. We’ve gone an unusually long period of time without such a downturn (the summer of 2011), so perhaps we are due. I wrote last month that the best course of action statistically is to assume any particular decline in a bull market is a correction and not the start of a new bear market (in other words, buy the dips). I wanted to stress that because many investors sweat the small dips in the market and therefore miss the big picture which is the overall bull market. That said, we’ve been running for a long time on the tail wind of low interest rates, which both increase profit margins for businesses (through lower financing costs) and make competing investments (such as bonds) less competitive. If one assumes the current environment of low interest rates and high profit margins can be maintained even without central bank assistance, then stocks may still be fairly reasonably valued and the bull market probably has more room to run. If rates begin to rise or profits begin to fall, however, in either scenario fair value would be quite a bit lower. We would suggest at this point that selling the rallies will be at least as productive as buying the dips.
Thoughts on Bonds
This is a time you want to own high quality bonds. Liquidity is far better in government bonds than in corporate bonds, so the combination of higher bid-ask spreads and a slowing economy will weigh on the latter. Municipal bonds have been largely immune from the bond sell-off (they tend to be closer to governments in terms of credit risk), but international bonds have been hit as hard as high yield corporate bonds due to the strength of the U.S. dollar. Expect that to continue. A hedged foreign bond fund (such as the PIMCO Foreign Bond (US Dollar Hedged) Fund) makes the most sense right now
Mutual Fund News
Without question the last few years have been a struggle for him. 2011 was a poor year for the PIMCO Total Return fund, the first in quite a long time. All of his underperformance (and then some) was recovered the following year. The fund then got whacked during the so-called “taper tantrum” in late May of last year, and has been mediocre this year. It has to be extremely hard to manage hundreds of billions of dollars for institutional and retail investors and be the face the organization. It seems to have taken its toll. In his mind, the move to Janus is probably similar to Jeffery Gundlach’s leaving TCW (minus the legal circus – hopefully). I can’t imagine it going that well for Mr. Gross. He is quite a bit older for one thing, and may not have the drive it will take to elevate Janus into the bond big leagues. He will be starting with a dramatically smaller asset base, so if there are plays to be made where nimbleness counts, he would finally have that advantage again. However, in the vast universe of broad based bond investing, scale may be more of an advantage than a hindrance. Small size would be better if he were running a muni or high yield fund but I’m just not certain it lends an advantage to Mr. Gross’s style of investing. Time will tell.
PIMCO Total Return
Dan Ivascyn has been tapped to run the Total Return Fund. He has put together quite an impressive record as the manager of the PIMCO Income fund, a multi-sector bond fund. That said, he has his work cut out for him. Income is a $38 billion fund, whereas Total Return has in excess of $220 billion (at least before Friday). Certainly there will be significant redemptions. Total Return’s size means that it relies on derivatives instead of individual bonds. What should one do? The biggest risk is to less liquid bonds, because redemption concerns will widen corporate and mortgage bond spreads. Holders of PIMCO’s closed-end bond funds had the most to lose because they were trading at a premium. I’m not really concerned about PIMCO’s open-end funds, though I believe Total Return and Income will modestly underperform in the short run due to volatile fund flows. Some alternatives to the Total Return fund include TIAA-CREF (TSBBX), Doubleline (DBLTX), Metropolitan West (MWTIX) and Dodge & Cox (DODIX). Feel free to contact us to discuss those funds.
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 All performance numbers are taken from JP Morgan’s Weekly Recap, 9-29-14. Small caps as measured by the Russell 2000, foreign stocks as measured by MSCI EAFE.
 It has been suggested that the recent IPO of Chinese internet firm Alibaba might mark a market top in the same way that the IPO of investment firm Blackstone in 2007 marked the top of the previous cycle.