3rd Quarter 2014 Investment Commentary
Third Quarter 2014 Investment Commentary
The quarter ended on a down note as global stock markets declined in September, leaving most broad market indexes we follow with losses for the quarter overall. In the United States, larger-company stocks managed a slight 1.1% gain for the quarter after falling 1.4% in September. (See our benchmark returns table for complete details.) Smaller-company stocks, which have had a challenging year so far, lost nearly 6% in September and were down 7.4% for the quarter. For the year to date, large caps have gained 8.2% versus a decline of 4.3% for the small-cap benchmark. Our portfolios are tactically underweight small caps—a beneficial stance given this year’s performance divergence between the two asset classes. Our view has been that while U.S. stocks, broadly speaking, are somewhat expensive relative to companies’ earning potential (i.e., valuations are high relative to fundamentals); small caps have been particularly overvalued and are, as an asset class, more vulnerable in market sell-offs.
Developed international and emerging-markets stocks fell during the quarter, particularly in dollar terms as the U.S. dollar rose against other currencies. (A stronger dollar reduces returns on investments denominated in foreign currencies.) The Vanguard FTSE Developed Markets Index lost 6.2% for the quarter and is now down nearly 2% year to date. Emerging markets declined 2.3% in the third quarter, though they remain up 3.7% for the year. The quarter’s financial market results were set against a now familiar set of macroeconomic and geopolitical considerations and concerns. These same issues have shaped markets over the course of the year as well. They include divergent economic outlooks around the globe, with the United States seemingly on a path of modest recovery, Europe facing stalled growth and potential deflation, and China continuing to seek a balance between maintaining sufficient economic growth on the one hand versus slowing credit growth and implementing economic reform on the other. Monetary policy is similarly varied. In the United States, the Federal Reserve’s wind-down of its quantitative easing bond-buying program (set to end in October) marks one milestone and focuses investors’ attention increasingly on the eventual hike in rates. During the quarter, Federal Reserve Board Chair Janet Yellen reiterated the Fed’s plan to keep rates at current levels for a considerable period of time after bond buying ends, leaving investors uncertain as to what that eventual policy shift will look like and when it will occur. Geopolitical issues (most recently with the escalation of U.S. military action in the Middle East) and stretched stock-market valuations in the United States are other key factors shaping performance. We review a few big picture issues a bit later in this commentary.
Core bonds declined very slightly in September as yields rose on the prospect of the Fed’s eventual exit from its easy money policies. For the quarter, the Vanguard Total Bond Market Index (our proxy for core bonds) was flat, though it remains up 4% for the year to date. High-yield bonds, which have been a bright spot for income-seeking investors, have had a choppy year and were down sharply in September as investors seemed to grow more cautious about taking credit risk for relatively little additional yield. This was a headwind for funds that own high-yield bonds or other types of credit-sensitive bonds, including corporate bonds and floating-rate loans.
From quarter to quarter, our longer-term (five-year) macroeconomic scenarios are unlikely to change, and this was the case in the third quarter. Similarly, in the absence of major market developments that might affect the attractiveness or risk of an investment opportunity, our outlook for individual asset classes has not changed materially from last quarter.
We’ve detailed our big-picture views and our outlook for the asset classes we hold in the past few commentaries. For this commentary we’ll give a brief update on a few key macroeconomic variables that we think are noteworthy and of particular importance for financial markets in the current environment. Then we will shift gears and revisit some timeless principles that form the bedrock of our investment approach at Litman Gregory. We’ll also tie these principles into our current investment views and portfolio positioning.
A Brief Macro Update
Global central bank policies: The statements and actions of global central bankers continue to exert a powerful influence on financial markets. As a result, we have found ourselves more attuned to monetary policy in recent years than in times past. This is due to the extraordinary measures taken by the Fed and the other major central banks in their efforts to avoid a worse economic downturn following the financial crisis and to support the resumption of a more normal economic cycle. Monetary policy remains one of the largest unknowns and risk factors as we look forward.
At their latest meeting in mid-September, the Fed continued on its course of ending quantitative easing bond purchases in October, as expected. The Fed also did nothing to dispel market expectations that they are likely to start raising the federal funds rate around mid-2015, given the current trajectory of economic growth and unemployment. Yellen again reiterated, however, that all of their decisions will be data dependent, not calendar driven.
While the market and the Fed are now in line in terms of the likely timing of the first rate hike, the market still does not expect the pace of rate hikes to be as aggressive as current Fed forecasts imply, using the median forecast of the Federal Open Market Committee members. So the potential for a market surprise in terms of higher and sooner rate increases exists. For example, as we write this, federal funds futures are priced for a 0.775% federal funds rate at the end of 2015, compared to the median federal forecast of 1.375%. For year-end 2016, the market is priced for a 1.865% federal funds rate versus the median of 2.875%. Those are meaningful differences. (Note, however, that the individual Fed member forecasts are spread across a very wide range around the median, which calls into question how reliable the median is as a single point forecast.)
The news from the European Central Bank during the quarter was perhaps more meaningful and highlighted the divergence among global central bank policies. In early September, ECB president Mario Draghi announced additional stimulative monetary policy actions in response to worsening eurozone economic data and deflationary indicators. The ECB not only cut rates but also announced its plans to buy private sector asset-backed securities and certain types of bonds backed by loans from banks, with the aim of increasing the flow of credit to the real economy (particularly to small- to medium-sized businesses). More broadly, Draghi said the “aim is to steer, significantly steer, the size of our [ECB] balance sheet towards the dimensions it used to have at the beginning of 2012.” This could imply roughly one trillion euros of additional asset purchases over the next 12 months.
The ECB will essentially “print euros” to buy the securities, so it’s similar to QE (where the Fed bought government bonds) but on a much smaller scale. In theory, buying the securities from banks will free up capital enabling banks to make new loans to businesses, stimulating growth. But the actual magnitude of these purchases remains to be seen. There are reasons to be skeptical it will have much impact given the small size of the ABS market, and that the ECB will only be buying the highest-quality tiers of the securities at this point.
If the ECB’s latest steps don’t do enough to move the economic needle, it may ultimately have to engage in large-scale QE—as the Fed, Bank of England, and Bank of Japan have done—in order to try to prevent deflation from taking hold in the eurozone. Deflation in Europe would obviously have very negative consequences for the global economy and equity markets. On the other hand, a strong shot of QE liquidity from the ECB could give a boost to global stock markets just as the Fed is starting to tighten U.S. monetary policy.
Key to the Fed’s monetary policy decisions is the outlook for inflation, wages, and employment. We provide short updates on recent developments for each of these variables below.
Inflation: In last quarter’s commentary we mentioned that U.S. inflation had recently begun to tick higher. We also noted that we weren’t making any new portfolio changes based on that data because (1) we didn’t view the change in inflation risk as significant, (2) we didn’t have a high level of conviction in an inflationary scenario playing out compared to other macro scenarios we consider, and (3) we had already positioned our balanced portfolios for the likelihood of rising interest rates, consistent with some increase in inflation over our five-year horizon.
In the most recent three months, the inflation rate ticked back down or stabilized at levels below the Fed’s long-term target of 2%. Specifically, the core CPI rate fell to 1.7% for the 12 months through August, while the core PCE inflation rate (the Fed’s preferred inflation measure) held steady at 1.5%. Inflation expectations remained relatively stable as well. With this inflation backdrop, the Fed has more leeway to remain accommodative and core bond interest rates are unlikely to move sharply higher. Extremely low rates in Europe and other developed economies also should contribute to keeping a lid on Treasury bond yields (i.e., Treasurys should remain in demand among global bond investors due to their relatively attractive yields as well as a strengthening U.S. dollar).
Wages: Wage growth is another economic indicator the Fed and the markets are watching closely. Both average hourly earnings and real (inflation-adjusted) hourly earnings increased slightly over the past three months to 2.1% and 0.4% year-over-year growth, respectively. But they remain well below what Yellen has said she wants to see as evidence of a healthy labor market—probably at least 3% nominal wage growth and 1% real wage growth. Broader indicators of labor’s share of the economy also suggest we are still early in the cycle of wage gains. As we’ve noted before, while additional wage growth and a rising labor income would be healthy for the economy, it has potentially negative implications for corporate profit margins (which remain around historical highs) and, therefore, earnings growth and stock market valuations.
Employment: On the employment front, despite a disappointing August number, job gains (U.S. nonfarm payrolls) continued to be reasonably strong—averaging 207,000 per month over the past three months through August. For the first eight months of the year, job growth has averaged 215,000 per month, the highest rate since 1999. However, the recovery in jobs following the 2008 financial crisis continues to lag what is typical after previous U.S. recessions. The unemployment rate dropped slightly to 6.1% in August, still well above the Fed’s estimate of “full employment” in the low-5% range. However, the labor force participation rate remains stuck at a 36-year low, exerting a downward bias to the unemployment rate.
Taking these and other employment indicators into account, the Fed reiterated its view that “there remains significant underutilization of labor resources.” Or as Fed chair Yellen put it more simply at her press conference following the September Federal Open Market Committee meeting, “There are still too many people who want jobs but can’t find them.”
As we noted at the outset of this commentary, our macro view has not changed over the course of the quarter. We continue to see the United States on a slow path of recovery with very gradual improvement in growth and employment. Much of the developed world is in worse shape, facing slower growth, higher unemployment, and worrisome deflationary trends. The role of monetary policy—specifically the timing and impact of the Fed’s gradual winding down of its stimulative policies—is a major unknown. While we didn’t discuss it in the sections above, we continue to monitor the risk of a greater slowdown in China’s economic growth, a risk factor that also hasn’t changed meaningfully over the past three months.
Knowing What You Can’t Know, Knowing What You Don’t Know, and Staying Disciplined in Your Investment Process
focus on the “knowable” (or at least that which is knowable with a reasonable degree of certainty)
“We try to think about things that are important and knowable. There are important things that are not knowable . . . and there are things that are knowable but not important—and we don’t want to clutter up our minds with those.” —Warren Buffett
Macroeconomic events (economic, political, geopolitical, etc.) obviously have a significant impact on financial markets and asset prices. Yet we’d put these variables in the “unknowable/unpredictable” bucket. That doesn’t mean that we don’t pay attention to macro developments—obviously, we do, and we discussed some key ones in the previous section. But we are by no means trying to predict what the next monthly or quarterly economic data point is going to be. It should go without saying that we also make no attempt to predict short-term stock market moves. (By short term, we mean anything less than about five years.) First, we wouldn’t be good at it. In our experience, no one is consistently able to get it right. Second, even if you get a macro forecast right, it doesn’t necessarily mean you will get the investment decision right because financial markets are driven by a multitude of factors on any given day and the correlations and interrelationships among these variables are often not stable. Instead, our investment approach is structured so that such forecasts are not necessary for achieving excellent long-term investment returns. Most of the great investors we admire do the same.
We also tend not to let geopolitical developments impact our investment views. We know there will be geopolitical conflicts: there always have been and it’s fair to assume there always will be. But we’re unlikely to have any unique insights into such events (e.g., Ukraine or the Middle East) that the market isn’t already discounting. There may be occasions where we see new and significant risks to our portfolios arising from geopolitical events that we believe are prudent to protect against. But within our investment approach, we more typically view geopolitical shocks as events that may create investment opportunities due to extreme short-term market overreactions. Taking advantage of such opportunities will more likely be a function of our ability to extend our investment time horizon relative to the market’s immediate, tunnel-vision focus, rather than our having a high-conviction and differentiated near-term view about any particular geopolitical outcome.
So while macro is often an important driver of investment results, at least over the shorter term, it is unknowable—or more precisely, it is consistently unpredictable. So what do we do? We build portfolios that should be robust and resilient across a fairly wide range of macro scenarios that we think have a reasonable chance of happening based on our analysis, experience, and judgment. But we avoid the futility of prediction and the false precision of relying on specific short-term macro forecasts for our investment decisions.
We primarily think about macro forces in terms of the potential risks they pose to our portfolios, across various scenarios. This has been particularly important in the aftermath of the financial crisis, when, for example, we expected significant impediments to global demand and slower growth as economies unwound their very high levels of debt. That led us to conclude we would not experience a typical cyclical recovery from recession. And that decision led us to be more defensively positioned than we otherwise would have been had we assumed a “normal” recession and recovery.
We also consider macro factors when thinking about where we may be in terms of economic, interest-rate, credit, asset class, or financial market cycles relative to long-term (normalized) trends and historical cycles. This may influence our portfolio positioning at the margin, in concert with our primary focus on longer-term fundamentals and valuations. For example, this is the case with our underweight to to small-cap stocks relative to large-cap stocks, where valuation is the primary driver but where cyclical factors are also supportive.
Our fixed-income exposure also clearly considers macro factors as it relates to central bank policy, inflation, and interest rates. We don’t have high-conviction short-term predictions for any of these variables—not even the Fed itself knows what it is going to do six months from now—so we incorporate a range of outcomes when constructing our client portfolios. What we do think is “knowable” is the likely range of returns for core bonds over the next five or so years. We know with certainty the current yield and how bond prices respond to interest-rate changes. So we can calculate the expected returns to core bonds across a range of interest-rate scenarios. And we can see that the returns fall into a relatively tight range and look unattractive across that range. This has led us to invest heavily in more flexible non-core fixed-income strategies, while still maintaining some core bond exposure for portfolio risk-management purposes in the event of an unpredictable recessionary shock.
On the other hand, while the mechanics of calculating expected returns for stocks are straightforward—a simple function of earnings growth, dividend yield, and a terminal P/E multiple—the range of potential equity-market returns across our macro scenarios is very wide. The central tendency of our estimates is below the historical average return and not sufficient in our view to fully compensate us for stocks’ downside risk. But we do not have a high level of conviction that one particular scenario will play out over others. To have such conviction, particularly in the current post-crisis environment, would suggest we know the unknowable (i.e., we’d be fooling ourselves). Our portfolio allocation to equities reflects this uncertainty and how we are weighing the distribution of potential returns; we are somewhat defensively positioned (underweight) but are maintaining meaningful equity exposure with a tilt toward non-U.S. stocks that have more attractive, longer-term expected returns.
As mentioned above, if and when there is an unexpected macro shock, we will evaluate whether the market has overreacted, potentially creating a highly profitable long-term investment opportunity for us. We saw such an opportunity during the height of the financial crisis in late 2008/early 2009, when we built a very large (15%) tactical position in high-yield bonds in our portfolios. From a macro perspective, we were not confident we had seen the worst of the crisis or that a severe recession and further market declines were not still on the horizon. But junk bonds were yielding over 20%, and our scenario analysis indicated that even under extremely pessimistic (Depression-era) assumptions we were likely to earn double-digit annualized returns over a five-year holding period. Despite the macro unknowns, we believed we were being much more than fairly compensated for the risks of owning high-yield bonds at that time. As it turned out, the market environment improved much quicker than we thought was likely, and high-yield bond prices and returns rebounded sharply as well.
As another example, although on a much smaller scale, in mid-2012 we added a tactical position in European stocks after they had been crushed in the face of heightened fear of a eurozone breakup. We weren’t making a macro bet on Europe. To the contrary, we thought there was a real risk of a eurozone breakup at that time. That’s why we only took a small initial tactical position, in order to manage the risk and allow ourselves room to add to the position if prices fell further. But even so, our valuation analysis at that point suggested the markets were overly discounting that macro risk; they were excessively pessimistic and fearful about the likelihood and impact of such an event. As it turned out, Draghi gave a speech shortly thereafter in which he pledged to “do whatever it takes to preserve the euro” and European markets rallied.
circle of competence: knowing what you don’t know
“Knowing what you don’t know is more useful than being brilliant” —Charlie Munger
A second core principle that underlies our investment approach is the importance of staying within your circle of competence. (A corollary is to work hard to expand your circle of competence over time.) This is another concept that investors Warren Buffett and Charlie Munger emphasize as critical to their investment success. It is also closely related to the first principle we highlighted, focusing on what’s knowable. Boiling it down, focusing on the knowable means knowing what you can’t know. Staying in your circle of competence means knowing what you don’t know.
Staying within your circle of competence means you don’t invest in things that you don’t fully understand. This requires being intellectually honest with yourself about what those things truly are. Or, as theoretical physicist Richard Feynman famously said, “The first principle is that you must not fool yourself . . . and you are the easiest person to fool.” Understanding the potential risks and how an investment is likely to perform in both absolute and relative terms across a range of possible scenarios is of paramount importance in our investment process.
But even with an understanding of the potential risks, there are many areas of the investment universe where we don’t go. For example, we get questions about investing in sector-specific ETFs, such as energy funds as a bet on the U.S. shale revolution, or health care and biotech funds. We don’t think we have an edge versus the market in evaluating sector-specific fundamentals and valuations, so we don’t invest in them. Instead, we delegate our underlying equity sector exposures to our active fund managers, who we believe do have an edge in picking stocks, operating within their respective circles of competence.
Another example of sticking to our circle of competence has been our decision over the past several years not to invest in gold. We can see gold’s potential value as a financial crisis hedge (i.e., as a form of portfolio insurance). But unlike traditional asset classes, gold has no yield and generates no profits, so we are unable to estimate its intrinsic value or long-term expected return with any confidence. Moreover, we know that gold has a lot of downside risk (e.g., the gold ETF is down about 35% over the past three years, which is probably the reason we aren’t getting any gold questions these days). This is not to say that no one can have an edge investing in gold—it may be at the center of some investors’ circle of competence (and some of our stock fund managers will invest in gold mining companies). But it isn’t in ours.
Despite a lot of time spent researching many aspects of gold as an investment, we didn’t get to a sufficient level of confidence to make an investment. However, there are many other asset classes and investment strategies that we’ve worked on over the years that are now within our circle of competence and in which we’ve invested. Examples include floating-rate loan funds, local-currency emerging-markets bonds, and various alternative strategies.
We know that by sticking to investments within our circle of competence, even as we constantly work to expand it, we will undoubtedly miss some great-performing investments. But we’d rather miss something because we are not confident we truly understand it or because it doesn’t fit within our investment approach than invest in something based on guesswork or hope or past performance, only to experience a negative surprise. If we stay within our circle of competence, our batting average (investment winners) should be high and our mistakes won’t be too detrimental. We think that’s an excellent recipe for long-term investment success.
a disciplined process
“Investment success requires sticking with positions made uncomfortable by their variance with popular opinion. Casual commitments invite casual reversal, exposing portfolio managers to the damaging whipsaw of buying high and selling low. Only with the confidence created by a strong decision-making process can investors sell mania-induced excess and buy despair-driven value.” —David F. Swensen, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment
(Free Press; Rev Upd edition, January 6, 2009)
There are many core beliefs that underlie Litman Gregory’s investment process. We’ve discussed two of them above, but within those discussions we also touched on or alluded to several other key investment principles: having a long time-horizon; remaining patient; basing decisions on valuations and fundamentals rather than short-term momentum or market sentiment; focusing on risk management and investing with a margin of safety; being willing to act with conviction when we believe the market is wrong, but also being intellectually honest and humble about what we don’t know and can’t know. All of these elements comprise our investment process. Our discipline in following this process is what enables us to consistently and successfully execute our investment decisions over time.
We strongly believe that sticking to one’s process—being disciplined—is critical. But there can be a fine line between being disciplined and being stubborn. We constantly challenge our own thinking to make sure we have not crossed that line. For example, for the past several years our valuation and fundamental analysis has indicated that U.S. stocks are overvalued, or, more precisely, that the five-year expected returns for stocks are unattractive relative to stocks’ downside risk across most of our range of likely economic scenarios. However, as the economy has slowly recovered from the financial crisis—thankfully avoiding our worst-case deflationary scenario—our assessment of the underlying earnings fundamentals and our valuation assumptions for stocks have also improved. Our decision to incrementally increase our equity exposure, among other changes, reflects this. Another example, moving in the other direction, was our reassessment of our emerging markets’ thesis earlier this year. This led to a modest downward shift in our scenario assumptions and return estimates. Again, our portfolio positioning reflects these changes. So we have followed our discipline over time by incorporating new information and data, updating our analysis, and, where appropriate, changing our portfolio positioning.
On the other hand, while our discipline requires us to adapt and change our views if the facts and circumstances change, it also protects us against getting swept up in the short-term noise and emotions of the markets. This is where our long-term investment horizon is most valuable, allowing us to step back from the unpredictable and focus on the reasonably knowable.
In the current environment, a great example of this is the argument that “stocks are the only game in town” because bond yields (and expected returns) are so low. And the related argument that, “as long as the Fed is accommodative, stocks are the place to be.” We have no doubt that both of these arguments are behind some or much of the ongoing rally in U.S. stocks. The stock market can be a self-fulfilling mechanism in this regard and we certainly can envision a scenario where this continues for some period of time. (Of course, the market can get into a self-fulfilling negative cycle as well.) But it is not sustainable. Our investment discipline doesn’t allow us to play this game because we know we won’t know when the music is about to stop. We don’t fool ourselves into thinking we’ll be the one that gets out the door before the party ends (the market drops).
So, we acknowledge that recent upward market trends may continue and, based on our longer-term analysis and focus on downside risk management, we may not be positioned to fully benefit from these trends. But we are unwilling to violate our discipline by throwing in the towel and saying, “What the heck! Everyone else is playing the game so we might as well play it too, let’s see if we get lucky even though our analysis says the odds are against us.” That is speculating or gambling, not long-term investing, and is certainly not appropriate for investors that worry about (or can’t afford to suffer) significant shorter-term portfolio losses.
In our investment analysis and decision-making we try to focus on what is knowable with a reasonable degree of certainty or within a reasonable range of outcomes and probabilities. There are times when what we determine is right for our clients’ long-term benefit is at odds with what the markets are doing in the short term. However, we believe our discipline in adhering to our circle of competence—our expertise as asset class analysts, fund manager analysts, and portfolio (risk) managers, and everything we have reiterated in this commentary about our investment process—gives us an edge that has enabled us to meet our clients’ investment objectives over time.
—Litman Gregory Research Team (10/1/14)