Where we stand in 2013: Learning from the past and looking ahead
As we enter 2013, I’m writing to summarize what happened in markets last year and to share my thoughts on positioning portfolios for the year ahead.
The so called “apocalyptic” year of 2012 saw a continuation of the volatility that’s characterized markets since the global financial crisis, which will be reaching its fifth anniversary this September. The U.S., Europe and emerging markets all showed strong gains in the mid-teens, despite concerns about Europe’s finances and worries that the US would fall off the “fiscal cliff” and go back into recession. And while the Canadian TSX market was up by almost 8%, it lagged the U.S. for the third straight year.
Much of 2012’s volatility was driven by the numerous good and bad news reports about Europe. Positive indications for Europe’s economy in the first quarter led to the strongest start for markets in recent memory, which was promptly given back as concerns rose in the second quarter. Markets then rallied in the second half of the year when the European Central Bank announced that it would provide liquidity to governments and financial institutions – to the point that for 2012 as a whole, Europe’s stock market actually outperformed the U.S.
The chart below shows returns for the past five years, all in local currency. Note that when including dividends, Canada, the United States and emerging markets ended 2012 above their high point five years ago, shortly after global markets hit all-time highs in the fall of 2007.
Putting big-picture problems in perspective
It’s easy to feel discouraged given all the bad news and problems facing the world. Recently, though, I came across a December 1990 article from the Knight-Ridder newspaper chain that helped provide some interesting perspective on today’s issues.
Here’s what was going on at the end of 1990.
1. In August of that year, Iraq invaded Kuwait. It was not until January of 1991 that a coalition of Western and Arab nations led by the United States responded. In the meantime, there was huge uncertainty about what would happen and oil prices doubled as a result.
2. Starting early that year, Western economies went into a significant recession, which hit its peak in the fourth quarter of that year. In the four months from July to October, the stock market was off 15% – for the year as a whole the market was down almost 7%.
3. In the aftermath of $500 billion in write-offs in the savings and loan sector, there was a widespread view that the U.S. was on the threshold of a full-fledged banking crisis. Loan defaults were up and bank profits down, 900 US banks had failed in the past five years and another 1000 were on the problem list. In response banks were cutting back on loans, even to credit-worthy borrowers.
Prices of bank stocks such as Citibank and Chase Manhattan Bank dropped by half from July to December in 1990. An editorial in Business Week had a typical view: “The banking sector is under enormous strain. Should it begin to unravel, recession could become an economic disaster.”
Of course, we now know that the 10 years beginning in 1990 saw strong growth in the economy and rising stock market. I’m not suggesting the same will happen today – but the global economy has worked through significant problems before, whether it was the issues in the early 1990s, or the shock in oil prices that led to a global recession in the 1970s or numerous other big picture problems.
Looking ahead to 2013
Even in the face of all the current global problems, many analysts are beginning the new year cautiously optimistic about the outlook for stocks. The reason is not because there is any expectation of an easy resolution to the developed world’s debt woes, unemployment or slow economic growth; there is universal agreement that it will take years to work through these.
The reason for optimism arises from the fact that around the world companies are generally in very good condition, with strong operating margins and solid balance sheets. An October interview in Barron’s magazine was a good example of the positive mood on stocks, in which 45-year industry veteran and former Morgan Stanley strategist Byron Wien explained the reasons for his positive forecast for the US:
· The US housing market has hit bottom and will be a positive force in 2013
· Growth in the middle class in emerging markets will continue to provide opportunities for investors and for companies selling into those markets (Wien is especially positive about agricultural commodities.)
· Dramatic new oil discoveries will put a cap on the price of oil and help buoy the US economy
· Large multinational stocks offer predictable growth, solid balance sheets, and attractive yields at reasonable valuations.
· Even in the face of challenges on budget deficits and debt levels, Wien points to the resilience of the US and its history of repeatedly working through what he refers to as “disasters.”
Here’s a link to the interview with Byron Wien, should you wish to read more: Wall Street Sage Sees Reasons for Cheer by Lawrence C. Strauss
The other major issue in markets is the direction for bond prices. There is growing concern among many leading strategists about the prospect for bonds based on current record low interest rates, despite their “flight to safety” appeal; indeed, a recent New York Times article titled “Bond craze could run its course in new year” pointed to research from Morningstar that bonds have grown from 14% of US investor portfolios five years ago to 26% today. Of note, this is at a time when Warren Buffett in his annual letter to investors last spring said that due to today’s low rates and inflation “bonds are among the most dangerous of assets.”
What this means for your portfolio
In my email at the end of last year, I outlined some guiding principles in my approach to building client portfolios, four of which I repeat here. Should you be interested in doing so, I’d be pleased to discuss these guidelines at our next meeting.
Over a retirement lifetime (25-30 years) the cost of living will likely double. The real risk we have is outliving our money as our life expectancies increase, increasing social and healthcare costs. Understanding our cash flow needs to insure our lifestyle and sources of income and managing their risks is critical. My starting point with clients is to identify the rate of return they need in order to achieve their retirement goals and then to construct a portfolio based on that return objective. My goal is to take the right level of risk for each client – enough that we can be fairly confident that over time you’ll achieve your objectives, without taking more risk than is necessary. 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.
2. Sticking to your plan
Regardless of what happens to markets in the short term, barring a significant change in your circumstances, we need to stick to the investment strategy we’ve agreed to. Some of you may recall my mantra of “The recovery is inevitable” when in early 2009 we faced what appeared to be an end-of-the-world scenario and some stocks hit lows they hadn’t seen in 20 years. At that time, I urged clients to maintain a core level of equity exposure, something that ended up working out well.
In light of stock valuations and the risk in bonds in early 2012, for some clients where appropriate we increased equity weights to the upper end of their range. Given strong stock performance in the last half of the year, for some clients at the top of their range last spring we recently rebalanced holdings to bring the equity weight back down within portfolio guidelines. 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 stocks over bonds
3. Diversifying portfolios
When building equity portfolios, I’ve always recommended strong diversification outside Canada. This helped my clients through most of the 1990s, then hurt them in the decade after 2000, then helped them again in the past couple of years.
Going forward, I have no idea whether the Canadian market will do better or worse than global markets, but I do know that we represent fewer than 5% of investing opportunities around the world. In addition, because of our resource focus Canada’s market will tend to be more volatile over time than those of the U.S. and yes, even Europe. For those reasons, I continue to recommend a higher foreign equity allocation.
4. Focus on cash flow
The final principle relates to the role of cash flow from investments. In an uncertain environment for immediate economic growth and equity returns, I continue to place priority on the cash yield from investments.
In my view, diversified funds holding certain REITs, investment grade corporate bonds, the better rated high yield bonds and dividend stocks in selective sectors continue to be attractive. However, when it comes to equities, we do have to be increasingly selective, however, as some stocks that pay steady dividends now look expensive by historical standards and show signs of stretched valuations – this is because investor appetite for yield has bid up prices of those dividend paying stocks.
I hope you found this overview helpful. Should you have questions about anything in this note or about any other issue, please feel free to give me or one of the members of my team a call.
And as always, thank you for the opportunity to serve as your financial advisor.