The first half in review: Wisdom from three veterans of 50 years on Wall Street
During this very hot and dry July, I’m writing to provide perspective on what happened in the first half of 2012 and to share my thoughts on how I am positioning mutual fund portfolios for the period ahead. To help do that, I have included comments from three longstanding veterans of Wall Street, one who made his career in stocks, the other in bonds, the third Warren Buffett’s teacher at Columbia who I’ve referred to in past emails.
Before we get into their views, here’s an overview of what’s happened so far this year:
The first half of 2012 was a tale of two quarters; the first quarter represented the strongest start for the U.S. stock market since 1998, with Japan turning in its best first quarter gains in 24 years. This was largely driven by a reduction of fears about Europe, as well as stronger economic data in the U.S.
The second quarter gave many of those gains back:
• Markets were driven by increasing concerns about the future of the European currency union and slowing global growth, accompanied by discouraging data on employment and renewed focus on the capitalization of Europe and some American banks.
• We’ve also seen a slowdown in China and India, putting downward pressure on the prices of oil and other commodities and stocks in general.
• There were signs of the European situation stabilizing; after being off 7% in May, markets around the world did recover with a 4% gain in June.
Here’s a summary of market performance in the first half of 2012, all in local currency. This understates returns from investing in the US, as the strong American dollar has boosted returns. With its resource exposure, Canada has continued last year’s pattern of being a global laggard.
2012 Canada U.S. Europe Emerging Markets Global Returns
Q1 +5% +13% +8% +11% +12%
Q2 (6%) (3%) (4%) (5%) (4%)
Year to Date (1%) +9% +4% +5% +7%
12 months (11%) +5% (8%) (6%) (2%)
Source: MSCI returns including dividends, all returns in local currency
At the beginning of the 3rd quarter, Europe continues to have structural issues as its banks are exposed to the debts of countries such as Greece, Portugal and Spain. Concern of these countries defaulting on their debt create fear in bank depositors and investors. In June Eurozone leaders reached an agreement to provide funds directly to banks rather than through these struggling countries – this was seen as a positive sign.
Emerging market growth led by China is slowing to 6 to 7% – which is still quite strong compared to Canada and the US – and from a larger economic base from just 5 years ago. China recently cut its interest rate which is expected to provide some stimulus. However, even moderate growth in China of 5% will grow global resource demand in the coming years.
The Bank of Canada is predicting slower growth for Canada over the next 4 to 5 quarters. However much depends on demand from the US and China.
The US is one of the bright spots – although growth has slowed there are many US company’s with strong earnings and growth potential. The important housing industry seems to be starting a turn around and the future of manufacturing in the US is strong.
The dilemma for investors: Volatile equities, unappealing bond yields
On the surface, investors today face a range of unappealing choices. While equities appear fairly valued by most measures, the second quarter saw volatility well above historical norms. Holding equities has always been risky if your time frame is short but geopolitical uncertainty and market swings make owning equities feel especially dangerous today.
There is considerable debate about whether equities are expensive, cheap or fairly valued. Some observers express doubts about the sustainability of today’s record corporate profit margins and the enduring impact of debt problems and slow growth around the world. US stocks also show up on the pricey side using models such as the valuation approach advocated by Yale’s Robert Shiller, comparing equity prices to average earnings over the past 10 years, adjusted for inflation.
On the other side, a fair number of reputable analysts view equities as historically cheap, pointing to attractive ratios of stock prices to book values and measures like multiples of earnings and cash flows. Indeed, using Robert Shiller’s multiple of average ten year earnings, Europe is inexpensive by historical standards. My view: for investors with a time horizon of 5 years or more, equities globally today provide fair value.
Bonds pose different risks; we’re seeing historically low interest rates, as central banks around the world keep interest rates down to stoke economic growth – which is not expected to change anytime soon. Given current inflation, in normal times we would expect to see interest rates about two percent higher than today, but of course these aren’t normal times, and of course holding cash to eliminate risk from stocks and bonds virtually guarantees depreciation of purchasing power. For many investors, cash gives them no chance of achieving the returns they need to achieve their long-term goals.
Clearly, every client is different and every portfolio is different. That said, even given short-term uncertainty in equities, I am recommending that clients move or stay in the upper end of the equity allocation in their investment policy. That decision is supported by perspectives from two respected investment veterans with long experience on Wall Street, Dan Fuss and Bob Farrell.
Dan Fuss: Replace market risk with company risk
Dan Fuss is Vice Chairman of Boston-based Loomis, Sayles & Co, with over fifty years of fixed income experience, he is one of the most highly regarded bond managers of all time. Still actively running money in his mid-seventies, the bond fund he manages has over $20 billion in assets and over the past 20 years is a top performer in its category.
In an April interview with Investment News, Fuss made an unusual recommendation for a bond manager – to sell bonds and buy stocks. (and he is not the only bond manager who has suggested that) The reason relates to the risk of rising interest rates . “We’re in the foothills of a gradual rise in interest rates,” he said “Once they start to rise, you’re probably looking at a 20- or 30-year secular trend of rising interest rates.” He went on to say that when the unemployment rate falls to between 6% and 7%, it’s likely that Ben Bernanke and the Federal Reserve Board will alter the policy that has been keeping the interest rate on the 10-year Treasury bill artificially low. “Once that happens, you need to get out of the market risk that’s in fixed-income and into the company-specific risk you can find in stocks,” Fuss said.
Bob Farrell: 10 Market Rules to Remember
In the 1950s, Bob Farrell attended the same Masters program at Columbia as Warren Buffett, studying under Benjamin Graham, considered the father of value investing. In 1957 Farrell joined Merrill Lynch as an analyst and stepped down as Merrill’s Chief Investment Strategist in 1992, although he continued to provide his perspectives through articles and media interviews.
In 1992, Farrell penned 10 rules on investing. Two of those ten are particularly pertinent today and give me encouragement about stock returns in the mid and long term period ahead.
Rule 1: Markets return to the mean over time
“Returning to the mean” is another way of saying that over time, performance on stocks will revert to historical averages. The long-term annual return in the US stock market going back to 1926 is 9.8% before inflation and 6.6% after inflation, what’s called the real return. Whenever you have an extended period in which returns exceed the long term average, chances are a period of under performance will follow, and the opposite applies as well; a long period of under performance will be followed by a period of above average returns.
The 1990s saw average real returns of 14.9% annually, the best decade on record. Then reversion to the mean kicked in and the following ten years saw an average annual loss after inflation of 3.4%. Add the two decades together and you get a real return that’s 1% below the long-term average. In essence, it’s taken the last decade to rectify the valuation excesses of the previous 10 years – but with that behind us, history (and Bob Farrell’s rule on reversion) suggest that long-term real returns going forward should be closer to the 6.5% average.
Rule 5: The public buys the most at the top and least at the bottom
Since the financial crisis, total assets in U.S. fixed-income funds have more than doubled to over $2 trillion, up from $1 trillion at the start of 2008. At the same time, we’ve seen record outflows from US equity funds. The same move to fixed income has occurred in Canada. To me, this is further indication that provided you have a timeframe of five plus years and can tolerate the kind of volatility we’ve seen of late, investing in a broadly diversified stock portfolio is likely to serve you well.
Here’s a complete list of Bob Farrell’s 10 Market Rules to Remember.
TEN RULES TO REMEMBER
What this means for your portfolio
In my April Newsletter at the end of the first quarter, I outlined some guiding principles in my approach to building client mutual fund portfolios which I repeat here:
1. For retired clients, I believe in maintaining secure, liquid funds to cover three years of expenses. Having that buffer means that we reduce the risk of having to sell holdings at depressed levels; this also lessens the stress and anxiety for us both.
2. The second principle relates to the allocation between equities and fixed income and comes from my third Wall Street veteran, Benjamin Graham, the Columbia professor I mentioned earlier under whom Bob Farrell and Warren Buffett studied. In a recently discovered 1963 talk, Graham gave this advice:
“In my nearly fifty years of experience on Wall Street, I’ve found that I know less and less about what the stock market is going to do but I know more and more about what investors ought to do … my suggestion is that the minimum amount (of the investor’s) portfolio held in common stocks should be 25% and the maximum should be 75%. Consequently the maximum amount held in bonds would be 75% and the minimum 25% … any variations should be clearly based on value considerations.”
Personally, as my time frame is 10 years or more and I feel equity valuations are low and risk in fixed income is high, my equity allocation is 100%.
3. Third, regardless of what happens to markets in the short term, we should adhere to the agreed to investment parameters, barring a significant change in circumstances.
Some of you may recall my advice in late 2008 and early 2009, as we faced what appeared to be an end of the world scenario and some equity funds hit lows they hadn’t seen in 20 years. At that time, I urged clients to maintain their equity exposure and we saw a strong recovery in late 2009 and 2010. Given strong stock performance in the first quarter of this year, some clients asked about increasing equity weight above the maximum boundary in portfolios, and in light of recent concerns about Europe some may have considered selling equities.
While I am always happy to discuss this on a case by case basis, I advise against deviating from the range that we established going into 2012. Note that given equity valuations and the risk in fixed income, for some clients we have recently increased equity weights to the upper end of their range. Of course market reversals from current levels are always possible; however, taking a long term view, at current levels there is a strong case for equities over fixed income.
4. When building equity portfolios, I’ve always advocated strong diversification outside Canada. This helped my clients when Canada underperformed in the 1990s and hurt them in the 2000s, when it outperformed. Going forward, I have no idea whether Canada will do better or worse than global markets, but do know that Canada represents less than 3% of investing opportunities around the world and we need to stay geographically diversified as a result. For anyone concerned about volatility, our concentration in resources means that investing globally should also lessen extreme swings in portfolio values.
5. The final principle relates to the role of cash flow from investments. In an uncertain environment and for clients with a need for income in the short to medium term or cash flow from investments, I continue to recommend corporate bond and quality dividend funds.
Should you have questions on anything I’ve covered in this note or on any other issue, please feel free to give me or one of the members of my team a call. As always, thank you for the opportunity to serve as your financial advisor.