Investment Commentary

First Quarter 2013 Investment Commentary

U.S.stocks posted a healthy 10.6% gain in the first quarter.Developed international stocks overcame ongoing issues in Europe to return 3.8%. But other asset classes were disappointing. Emerging-markets stocks lost 3.5%, the broad U.S. bond-market benchmark was flat and foreign government bonds lost about 3.7%. Gold and gold stocks lost about 20%.

Our portfolios faced at least three market headwinds as a result of our positioning: Our portfolios are a bit underweight stocks and overweight lower-risk asset classes and investment strategies. Within our stock exposure, we are a bit underweight U.S. stocks and a bit overweight emerging-markets and developed foreign stocks. Within our U.S. stock exposure, we are underweight small-cap stocks and overweight large-caps. Small cap and lower quality stocks outperformed during the quarter.

On a bit more positive side, our actively managed bond funds continued to add value relative to the core bond index (Barclays Aggregate Bond Index).And our tactical position in floating-rate loan funds and mortgage REITs also added some value.

Supported by Federal Reserve Stimulus, U.S. economic fundamentals have continued to slowly improve. Unemployment is slowly falling, home prices have been rising, and corporate earnings and profitability are near record highs. Fed actions have also continued to support—and drive—strong U.S. stock market gains.

Looking ahead, significant uncertainty surrounds fiscal and monetary policy in terms of what policies will be adopted and their ultimate economic and financial market impacts. More generally, high global debt levels create an economic concern.  

Against this environment, my outlook for stocks has not improved. If anything, given the sharp run-up in stock prices, I am more of a mind to reducing our U.S. equity exposure further than I am to increasing it.

I continue to find emerging-markets stocks attractive, both relative to U.S. stocks and in absolute terms over our five-year time horizon.

Most parts of the bond market offer low longer-term return potential particularly given the expectation for rising rates over our five-year investment horizon and I continue to favor actively managed bond funds.

First Quarter 2013 Investment Commentary

What Now for U.S. Stocks?

With U.S. stocks hitting new highs, two questions arise:

1)      With stocks up so much, shouldn’t we decreaseour exposure (to lock in gains, given all of the big picture risks)?

2)      With stocks up so much, shouldn’t we increase our exposure (since the economy must be much better than people expected)?

My short answer to both questions is, not right now. Overall my outlook for stocks has not improved, and, if anything, in light of the sharp run-up in stock prices, which implies lower futurereturns over the next few years, I am more inclined to reduce our U.S. equity exposure than I am to increasing it.

I consider the upside return potential of the U.S. equity market from this point to be insufficient to compensate us for the downside risks related to overweighting U.S. stocks. However, there appears to be an unusually wide range of possible outcomes for economic fundamentals and their affects on our investments. This includes some positive scenarios for U.S. stocks (with annualized returns in the low double digits), as well as some very negative outcomes as the U.S. and the entire global economy works through the consequences of the financial/debt crisis of 2008. It appears that the weight of the evidence tilts more toward the less favorable side of the distribution of possible outcomes. But I do not have a high level of confidence in predictions for any one particular scenario playing out.

To some extent, I amhedging my bets and using lots of diversification—that just seems to be the prudent thing to do in an environment this uncertain. I am constructing portfolios that I believe should perform reasonably well across a rangeof potential outcomes, any one of which appears to have reasonable odds of actually playing out. But if one of the more extremely negative or positive scenarios unfolds, our portfolios are not going to do as well (at least over the shorter term) as a portfolio that has made a big concentrated bet on that particular outcome. Of course, if a particular extreme scenario doesn’t happen, then those extremely positioned portfolios would experience commensurately poor performance. I don’t think making a big bet on an outcome that can’t be determined with confidence is in the best interests of my clients.

The Environment: Policy Uncertainty and Modestly Improving Economic Fundamentals

A major contributor to the uncertainty we face in today’s environment revolves around government policy, both fiscal and monetary. It seems impossible to predict what policies will be adopted as well as their affect on the economy and our investments. The purpose of “quantitative easing” (QE) is to create discomfort and cause a search for higher yield. Equity prices have been driven up because investors have been tempted by currently higher returns on stocks. That appears to be a result of unsustainably high profit margins, which are now 70% above their historical norm. A lot of the high profits can be attributed to extremely low borrowing costs and extremely high leverage. So, it appears that QE and ZIRP (zero interest rate policy) have distorted investment markets and pushed investors into riskier assets. But it appears that QE and ZIRP have failed to produce durable economic growth. Ordinary forces like hard work, savings and investment create sustainable growth. I don’t think economic activity generated just by some change in what we do on the policy front will end well. 

With respect to fiscal policy, in the first quarter the markets dealt with the sequester’s spending cuts without much excitement. But the sequester’s impact (estimated at around a 0.6% hit to GDP growth in 2013) seems small potatoes compared to the debt and fiscal policy challenges that still face the nation. I would agree that there is not an immediate federal budget deficit crisis. And I agree that there is a real risk of snuffing out what remains a weak economic recovery with too much near-term fiscal austerity. However, there is clearly a debt and deficit crisis, at least in the medium to longer term, given the mismatch between federal revenue and spending. This calls for a strong and realistic longer-term fiscal policy response and the sooner the better. Maybeour political leaders in Washington are starting to get the message that needed changes can’t be delayed forever. If so, that could be a major positive catalyst for both the financial markets and the real economy. On the other hand, it may yet take a crisis to create the political will necessary to implement meaningful structural fiscal changes.

On the monetary policy side, there is more clearness at least in terms of the policies already in place. The leadership of the Federal Reserve (Chairman Ben Bernanke and Vice Chair Janet Yellen, among others) continues to be very vocal in stating that the Fed is not close to starting to unwind their stimulative policies, which involve purchasing $85 billion per month of Treasury bonds and mortgage-backed securities and holding the federal funds policy rate near zero percent. But there is significant uncertainty as to the medium- to longer-term outcome and unintended consequences of these policies and whether or not the Fed’s eventual exit plan will be executed successfully and without significant damage. Based on the Fed’s historical record of policy overshooting—and just the inherent complexity of the task at hand for anyoneto get it right without a lot of luck—most are skeptical.

In the meantime, Fed statements and actions continue to be an important support and driver of short-term stock market performance. While central bank actions have always influenced the stock market, the markets appear particularly dependant on ongoing highly accommodative Fed policy. Again, over the near term, there doesn’t appear to be any reason for Fed policy to become restrictive. So that leg of support to the markets is likely to remain in place. But the uncertainty increases as the time frame extends, and confidence in my ability to be “ahead of the market” in assessing a change in QE and ZIRP and repositioning our portfolios accordingly is very low.

Supported by accommodative monetary policy, U.S. economic fundamentals have continued to reluctantly improve. The unemployment rate continues to slowly fall, although that’s partly driven by a particularly sharp drop in the labor force participation rate, meaning there are fewer people working or looking for work—which is not a good thing. The housing market is improving, although mortgage lending to households remains tight. Household wealth is growing, driven by stock market and housing price gains—a key goal of the Fed’s QE program. Finally, corporate earnings and profitability are around their all-time highs. (That said, S&P 500 earnings growth in 2012 was actually slightly negative for the year; the market’s 16% return in 2012 came from stock valuations getting richer, not profit growth.) But concerns about the impact of global debt-deleveraging on economic growth and corporate profits remain.

Outlook for Stocks

It appears that a small underweight to the U.S. equity market, especially small caps and lower quality stocks is warranted. However, and importantly, our portfolios still maintain significant exposure to U.S. stocks because analysis suggests that stocks should perform at least reasonably well, both in absolute terms and relative to other competing asset classes and strategies.

In mid 2012, I added a small amount to European stocks because I thought their valuations were depressed, with potential upside more than sufficient to compensate us for the potential downside risks over our five-year tactical investment horizon. My short-term timing was lucky and European markets went on to significantly outperform U.S. stocks for the remainder of the year. However, with recent developments in Cyprus, expected returns for Europe came down further and no longer appeared to offer an adequate return premium.

I have added a bit to our allocation to emerging-markets stocks. I think the five-year outlook is good, but emerging-markets stocks underperformed U.S. stocks significantly in the first quarter. The recent underperformance increases my expectations for emerging-markets stocks to outperform U.S. stocks going forward.

Update on Bond Markets and Fixed-Income Positioning

The big-picture bottom-line is that the fixed-income marketplace, particularly the highest quality parts, appears to offer measly longer-term returns in light ofthe expectation for rising interest rates over the next few years.Most areas of fixed-income are trading at historically high prices, and yield levels are at or near historic lows.

What this means in terms of our fixed-income allocation is that our portfolios remain heavily underweight to core investment-grade bond funds, at about half of our strategic target weighting. In their place I have large allocations to flexible and absolute-return-oriented bond funds that I expect to outperform the core bond index over the next few years.

Concluding Comments

Investing is like a marathon, not a sprint. The key is to maintain discipline. The longer term investment climate can be analyzed with greater confidence and assets can be allocated accordingly. But reaping the benefits requires enough discipline to work through unavoidable shorter term gyrations that are impossible to predict with consistency. Succumbing to the temptation to jump into “what’s working” based on a recent run of outperformance (i.e. U.S. stocks) is a path to disappointment and subpar long-term investment results.

As always, I will continue to work hard to make the best investment decisions I can on your behalf, taking into account your long-term financial goals and your personal risk tolerance. With that said, if YOU want to be more aggressive please let me know. We can at least talk it over and come to a decision that suits you best. My job is to serve you and I thank you for the opportunity to serve.

Gary