Such bravado among experts can lead to disaster as well: as evidenced by this years' pace in which hedge funds (run by supposed masters of markets employing the most sophisticated strategies) have failed---a pace not seen since the 2009 meltdown, when 1,023 closed up shop. No need to investigate the whys, the markets tell the story. Which would be really big commitments to any or all of the following: Going long (owning) the energy sector, other commodities, non-US developed markets and non-US emerging markets---and going short (selling) the U.S. market (save for energy), particularly interest rate sensitive utilities and the asset class that simply had to give way to higher interest rates (that never came), bonds.
In last year's year-end letter I offered up my view of where I humbly saw the best opportunities in equities going forward and to what extent we would attempt to exploit them in our clients' portfolios. And while on a sector basis three out of our six 10%+ recommended weightings posted nice double-digit gains, we missed the boat on the two best performers (health care and utilities). And our non-U.S. allocation---which we bumped up at the beginning of the year---got creamed. Here are the 10%+ sector targets we set at the beginning of the year and the year-to-date (12/30/14) results (according to Standard and Poor's) for each respective S&P sector index:
Technology target: 15-20%, YTD return: +19.6%
Financials target: 15-20%, YTD return: +14.5%
Materials target: 10-15%, YTD return: + 5.7%
Industrials target: 10%, YTD return: + 8.6%
Energy target: 10%, YTD return: - 9.3%
Staples target: 10%, YTD return: +14.2%
Given that the S&P 500 Index is up 12.55%, the above---save for materials and especially energy---doesn't look too shabby. Well, if we had every client's portfolio allocated 100% to U.S. stocks---while it wouldn't have been a repeat of 2013 (a very good year)--- results would've been on par with the S&P 500. However, alas, 100% to U.S. stocks wasn't our positioning in 2014, as it has never been. We did the usual: diversified globally across many sectors and tipped the weightings at the margin to the sectors and regions we believed presented the best long-term opportunities. The hit to energy along with the hit to our non-U.S. exposure, which we bumped up in many portfolios last year, did a number on the bottom line relative (to the U.S.) results. Here are the non-U.S. targets and results of the related S&P indexes:
Non-U.S. Developed Markets target: 25%, YTD return: -6.31% (S&P Developed World ex-US)
Non-U.S. Emerging Markets target: 7.5%, YTD return: -2.34% (S&P Emerging)
So, when we take a hit on 35-45% of our stock exposure (U.S. energy plus the two non-US categories) in a calendar year, we're going to be hard-pressed to capture the entire gain of the major U.S. averages (in that calendar year)---always accounting, that is, for our overall exposure to equities (i.e. the index return is multiplied by a portfolio's actual equity target % to determine the relative results). That said, a critical key going forward will be to not react as if we are hard-pressed to, say, blow away the S&P 500 in the coming year. That emotion, I assure you, is what's led to the populating of the hedge fund graveyard these past few years.
In fact, even thinking in terms of "the coming year"---or in one-year increments at all---is an ill-advised way of approaching the business of investing. Whenever someone says to me "Marty, I have a chunk of money that I won't need for a year that I'd like you to invest for me." Without exception, I decline. Same goes for two-year, and even three or four-year commitments. The markets are far too unpredictable to devote to them what I view as short-term monies. When we get to five plus years, we can talk.
In that vein, when I, for example, make a case for non-U.S. equities, while I may be thinking that next year will see share prices outpace the domestic market, I'm actually thinking---in terms of holding periods---well beyond the next twelve months. In essence, all we can do is recognize value when we see it---the market will determine the time frame in which it will reward our insights, if at all. And, alas, it loves to test our patience. Bottom line: If we're married to an objective of beating some benchmark on a yearly basis, we might find ourselves abandoning a fundamentally sound approach mid-stream and missing the outsized gains that tend to find their way to the underpriced regions of the world. Same goes for sectors.
So here's what I'm thinking going forward:
Starting with fixed income...
Being wrong is okay when it means being early:
On December 5th, 1996 Alan Greenspan warned the world of irrational exuberance taking hold of the stock market, particularly the tech sector. As it turned out he was onto something, he was just three years early. Heeding his warning would have initially been painful as the NASDAQ Composite index shot higher the following three years. However, one would have avoided the mother of all bear markets as the tech-heavy index plunged nearly 80% between March of 2,000 and March of 2003. I recall toward the tale-end of the '90s receiving some pushback from clients as we rotated away from tech. I wasn't predicting the collapse, I was just paring back what had become an over allocation (as tech stocks ran up) and reducing exposure to a sector that by historical norms possessed valuations that looked very stretched.
From 2004 through 2006 we reduced or, in many cases, entirely eliminated our clients' exposure to real estate mutual funds. While my sense was that the sector had gotten ahead of itself, it took until the spring of 2007 for that opinion to begin to make sense from a share price perspective. And, believe me, it was tough watching those shares move higher in the wake of those sales. But my was I glad we sold---$15,000 in the Franklin Real Estate Fund in early February 2007 would've been worth roughly $3,500 on March 6, 2009. While that period was no fun and games for the rest of the market (although 2007 wasn't bad), virtually nothing got hit like real estate.
Probably the simplest to understand relationship in investing is the negative correlation between bond prices and interest rates. And going into 2014, after a prolonged period of record low interest rates---and a rough 2013 for bond investors---the consensus was that it would be an outright ugly year for the bond market as, surely, interest rates had to begin rising. I shoulda---given all my preaching of the dangers of following the crowd---known better. As it turned out rates trended lower from beginning to end and bonds did just fine (reminiscent of our early exodus from real estate in the mid 00s). But the thing is, given that at our shop our portfolios' fixed income component is there for safety, and considering that "simplest to understand relationship" between bonds and interest rates---consensus following or not---I couldn't bring myself to meaningfully buy bonds amid history's lowest interest rates.
Going into 2015 there's a case to be made that, amid incredibly low interest rates among other developed nations, the U.S. treasury will remain the sovereign debt issuer of choice. And, therefore, despite the seeming inevitability of a Fed funds rate hike, there'll be no grand exodus from the U.S. bond market. There are other cases being bandied about (ex: the likes of Bill Gross and Paul Krugman believe disinflation, a very strong dollar and low oil prices will keep the Fed on hold and interest rates very very low for longer than the market may now be discounting), but that in my view is the most credible.
So then, should we maybe dip our toe back in and take a position or two? Maybe invest in the Janus bond fund managed by Gross? I say absolutely not! That would, or might, be akin to Greenspan retracting his irrational exuberance statement just before the great tech collapse. You see, it's paid to this point to follow the Fed into the long-end of the yield curve (that would be quantitative easing), but that's over with. Now the Fed has to figure out how to ultimately unload some of that $4 trillion monster of a balance sheet (whether by outright selling or by simply not reinvesting the proceeds from maturing bonds). And, trust me, you don't want to be a buyer in that environment, regardless of how bonds shake out in 2015.
Last year's winning sectors that we missed:
As investors tend to buy utility stocks for the yield, and as utilities are considered a defensive sector (good to own when the economy's weak), given the interest rate environment, the prospects for economic growth heading into 2014, and what I viewed as stretched valuations, the one sector I had virtually no interest in at the beginning of the year was utilities. And go figure, the S&P Utilities Sector Index is up 26.6% year to date. Humbling! Irrational exuberance among utility stock investors? I think so. We're heading into 2015 with yet lower interest rates, a better looking economy and, in my view, really stretched valuations.
Surely the Affordable Care Act is a game changer for the health care sector. If everyone has coverage, providers are getting paid. That must mean better revenues and, consequently, higher stock prices. While we didn't entirely abandon the sector, we kept our average weighting in most portfolios in the 6 to 10 percent range. Despite the improved prospects for reimbursement, the defensive nature of investing in health care (I like hc when the economy's struggling. I.e. while you won't buy a new house or a car when you fear for your job, you'll still seek attention when your belly aches) and their stretched valuations heading into 2014 left me uninterested in increasing our exposure. And go figure, the S&P Health Care Index is up 24.5% year to date. Yeah, humbling... Irrational exuberance among health care stock investors? Not sure... There are some interesting companies, particularly in biotech, that probably deserve a look. That said, I'm going to recommend a continued modest allocation given present valuation levels.
Reasonable valuations, expectations of an improving economy, and the potential for capex spending (businesses investing in expansion) inspired our 15-20% target weighting to technology stocks. As stated above, the S&P Information Technology Index is up 19.6% year to date. As we enter 2015, valuations remain in my view okay, the economy seems to be gaining a little momentum, and the prospects for capex are stronger than they were a year ago. Thus, I'm recommending the same target going forward.
Cheap valuations and the prospects for an improving economy inspired our 15-20% target to the financial sector. The S&P Financial Sector Index is up 14.5% year to date. If in 2015 interest rates rise in an orderly fashion in response to an improving economy, lenders can realize the best of both worlds: better margins and growing loan demand. Financials are heading into next year sporting the lowest forward price to earnings (p/e) ratios among the major sectors. We're, therefore, maintaining that 15-20% target going forward.
Reasonable valuations, the mid-late cycle nature of the sector and the prospects for an improving global economy inspired our 10% target weighting to the materials sector. As it turned out materials stocks didn't produced the relative results the above logic might have suggested. The S&P Materials Sector Index is up 5.7% year to date. While the U.S. economy is gaining traction, and I don't see huge risks of deep recessions in many foreign markets, we're going to stick with our 10% target weighting going forward.
You want to own industrial stocks when you expect the economy to improve---as long as they present reasonable valuations. And going into 2014, both factors prevailed. The S&P Industrial Sector Index is up 8.6% year to date. In fact both factors remain going into 2015. We're bumping our target allocation up a bit, to 12%, for the time being. Expect industrials (particularly the transportation component) to outperform going forward should energy prices remain low.
Ugh! Despite increasing North American production, I was quite bullish on the energy sector going into 2014. So much so that in the portfolios of willing clients we went a little beyond our 10% target. Half way through the year I was feeling pretty smart, given the impressive 15% gain to that point. I've devoted a few recent commentaries to the whys of the energy sector collapse, so I won't delve here. Suffice it to say that energy stocks have gotten absolutely creamed the second half of the year. The question going forward is, do we jump all over them at these depressed prices? Perhaps we should, but let's not for now. Instead we'll simply rebalance (buy) back to that 10% target and expect that the forces of supply and demand will make sense of oil prices as we go forward. But, hey, let's not complain if energy prices stay low. As I've stated emphatically the past few weeks, for the U.S. and Europe in particular, this is one heck of an economic stimulus!
I was a little reluctant targeting staples at 10% at the beginning of the year. Valuations were not compelling and they're the place we go when the economy isn't, well, going. Nonetheless, in the interest of maintaining balance and playing a little defense we kept the weighting healthy in most portfolios. And good thing, because the S&P Consumer Staples Index is up 14.2% year to date. That 10% target is where we'll stay for now.
Mostly due to stretched valuations (after a phenomenal 2013), I was not---despite my optimism over the economy---at all bullish on consumer discretionary stocks (up 8.4% year-to-date) going into this year. Therefore, our portfolios have, on average, maintained a little less than 10% exposure. Well, I've just recently begun adding them again where I see an underweighting. While, in the aggregate, the stocks that make up the S&P Consumer Discretionary Index are trading at a not cheap 16.9 p/e, their 11.86 projected earnings growth rate makes the p/e to earnings growth (PEG) ratio---a popular valuation metric---reasonable. Factor in growing consumer optimism, an improving jobs/wage picture and lower energy prices, and one should feel okay about the this space going forward. I'm recommending a solid 10% weighting for now.
Other areas of interest:
Woe are those who bet that money printing galore had to lead to great gains in commodities prices. Even a modest allocation to a commodities fund this year dealt pain to one's overall results (DBC, the commodities futures ETF, has tanked 26.6% [according to Morningstar]). And bearishness reigns going forward. An already really strong dollar, the prospects for even further gains (in the dollar) considering potentially higher U.S. interest rates, foreign currency printing throughout much of the rest of the world, and the expectations that China's economy, for example, will not regain its momentum anytime soon have the "experts" painting yet more bleakness for commodities investors.
Now that, my friends, is a contrarian's dream. When the trade is overwhelmingly tilted in one direction you generally want to buck the tide. Plus, I have to believe that much of what's expected next year is already priced into the dollar. And, if so, what happens if China gets off to a better than the anticipated 7% annual pace early in the year? And what if when the ECB ramps up QE (Euro printing) foreign investors plunge into the Euro Zone equity markets (and, therefore, the Euro) and effectively offset the expected fall of the Euro? And what if we do see inflation pick up as oil finds a bottom and the now optimistic consumer gets busy consuming? Trust me, any or all of these possibilities could see investors flocking to commodities, those ever-popular---and now cheap---hedges to a falling dollar.
So do we, say, dump something and load up on commodities? Well, not if you don't have nerves of steel and an iron stomach. Commodities are the definition of volatile. And besides, if you're our client, you are indeed exposed; through your energy sector and materials sector allocations. And a few of you steely-nerved and iron-stomached individuals do hold a more direct commodities position or two. I'm simply suggesting that we shouldn't be too surprised if the consensus on commodities gets surprised at some point in the not too distant future...
Many times over the years I've dubbed, or (as I'm sure I heard this from someone else) redubbed, "it's different this time" as investing's most dangerous four-word phrase. Well, actually, it is different this time. That is, housing has definitely not led the way during this recovery, as it has---in terms of the rate of growth---during past recoveries. Which shouldn't come as a surprise given that it was the housing bubble that burst all over the global economy in 2008. But it's almost 2015, which means the first round of folks who had to go the distance and declare bankruptcy are reaching the point that brings them credibly back into the housing market. The employment indicators, as I've been reporting for months---as well as the jobs numbers themselves---are finally picking up measurably, wages are beginning to creep higher, consumer sentiment is hugely positive and the NAHB Housing Market Index has been dancing between 50 and 60 (57 recently) since July---above 50 means there are more optimists among home builders than there are pessimists.
Now we can get really deep into the weeds and talk about demographics and household formations, both of which speak positively going forward, but suffice it to say that it makes sense that, again, given the nature of the last recession, a pickup in the economy might very well unleash a good deal of pent up demand onto the housing market. Plus---and this is a huge plus---the housing-related companies that comprise the S&P Homebuilders Index are, in the aggregate, trading at 14.5 next year's estimated earnings against an earnings growth rate of 13.6%: That's a PEG ratio of nearly 1, which makes it very cheap relative to other U.S. sectors. Oh, and the index is up a paltry 2.1% year-to-date (i.e. no worries about buying into a runaway sector).
So do we add a little homebuilders exposure? Yes, I think we do. But, like everything else, in moderation, and with a long-term, volatility-tolerant, perspective.
I know, this letter's getting long, and thanks for hanging in there. Of all the stuff contained herein, the following, in my view, is the most compelling:
Japan has a problem that Prime Minister Abe can't fix by printing money. Japan needs to print babies, or open its borders (while there's been some proposals in the works, Japan's leadership continues to ignorantly, or, more truthfully, politically, resist reforming its disastrous immigration policy). You see, its population is shrinking. And while I suspect you'll find economies throughout history that fared poorly (which was the stuff of bad governments) as their populations grew, you'll not find any history of economies that thrived while their populations shrank (think this through before siding with those who'd kick out the "illegals" and fence the borders [reach out to me if you're open-minded and need some convincing]).
You've been warned for years about the graying of America. But you've heard nothing about the graying of India, Brazil, Mexico, Indonesia and South Africa (I could name many more). China is almost on a par with us in terms of median age. When you read the 2024 version of this letter, I suspect, with great confidence, that the best economies of the prior decade will have been those we call emerging. Why? Because the emerging markets are where everybody---well, 85% of world's population---lives. And that's where populations are growing. And that's where Apple will sell the most iPhones, Domino's the most pizza, GM the most cars and pfizer the most meds in the years to come. And that's where folks will overcome their present limits and---make no mistake---that's where many of tomorrow's great companies will be born.
As I've been reporting, emerging markets, as a group (or an index), have not been the most profitable investment destinations the past couple of years (consequently, valuations for many of these countries' markets are amazingly cheap relative to the developed world). Currency flux, capital flows and flight, fiscal and monetary policy mistakes and the coming and going of capital controls (not to mention the occasional military conflict) can make investing in emerging markets a breathtaking affair. There will absolutely be years, like 2014, when a 7.5% allocation, or more if you love roller coasters, will weigh down your portfolio's overall results. But then there were those years like 2006, 2007 and 2009 when VWO (Vanguard's emerging mkt ETF) returned (according to Morningstar) 29.5%, 39.1% and 76.3% respectively (vs. 15.8%, 5.49% and 26.5% respectively for the S&P 500).
If you're wondering why the seemingly most obvious of our investment destinations occupies the smallest equity allocation within our typical client's portfolio, it's the volatility. Most folks don't much enjoy investment roller coasters (except, that is, during the incline).
I'll stick with the 7.5% recommended target. We can talk individually if you'd like to consider going higher, or lower.
Non-U.S. Developed Markets:
As previously stated, international equities have not contributed to our porfolios' bottom lines of late nearly to the extent the U.S. exposure has. And for good reason---the U.S. economy has been the one bright spot, lately, among the world's developed nations. But, you know, political and central bank meddling notwithstanding, economies (even Japan's, ultimately) are cyclical. And I strongly suspect that when you read the 2024 version of this letter, I will be offering up some narrative about how the economies of the Euro Zone had expanded, contracted and expanded again over the course of the prior decade. And with an attractive aggregate p/e, a decent anticipated earnings growth rate, and more monetary accommodation ahead---not to mention profit margins that, unlike the U.S., are nowhere near their all time highs---I'm thinking the Euro Zone makes for a legitimate investment destination going forward. Hence my recent recommendation to bump up (a little) that exposure.
Per the above, Japan does not impress me. But that doesn't mean there aren't investment opportunities to be had in the great shrinking nation. The companies comprising the MSCI Japan Index are, in the aggregate, trading at 13.7 times next year's earnings. Throw in an earnings growth rate of 11.92 and you get a 1.15 PEG ratio---that's attractive. And factor in a central bank policy that'll remain the definition of easy for the foreseeable future, and you might do okay owning Japanese stocks going forward. While perhaps I should, I'm not recommending a Japanese-specific allocation at this time. But I'm feeling okay about that 21% exposure in EFA (the developed mkts etf we use widely) and the 9 to 11% Japan position in the international mutual funds some of our accounts hold.
The above logic aside, the simple fact that U.S. equities encompass merely 34% of the world stock market---or, frankly, that two-thirds of the world's growth opportunities lie outside the U.S.---virtually demands that we avail our portfolios to some of what the outside world has to offer.
I'll close here with a repeat of some common sense and two timeless bottom lines from last year's letter, a personal message, and a video that beautifully emphasizes why we should always maintain a global perspective:
Now, as scientific as you might imagine our selection process to be, there’s no assurance that the above allocation will deliver improved results at the margin (which is what we’re after). I can easily articulate a scenario for every one of the above sector picks that would logically counter whatever I believe justifies its 10+% weighting. And that’s essential to the process: For me to take, for example, a given client’s exposure to materials stocks from, say, 4% to 10%, there has to be investors (holders of materials stocks) out there who think that’s a bad idea—who are looking to unload their positions onto fools like me. Without opposing views (buyers and sellers) there’d be no market. You can, therefore, see why diversification is so important.
Beyond asset class and sector selection, there’s the real important stuff—the stuff that goes on between the ears: Like maintaining a proper perspective on volatility and asset allocation. Like understanding the opportunities that lie beyond our borders. Like understanding the cyclical nature of the economy and the influence of monetary policy on the cycle and on the pricing of fixed-income securities. Like never making emotionally-based investment decisions. And like understanding that, politics notwithstanding, our future is as bright today as it’s ever been.
The Bottom Line – investment-wise
The unpredictability of markets, while unnerving to some, forever offers opportunity for the disciplined investor. In fact, long-term investment success is indeed all about discipline. Investment mistakes are typically emotionally-driven. Fear can drive an investor out of equities long before his/her financial plan would have called for. Typically, and ironically, the times of extreme panic have tended to be extreme buying opportunities. Conversely, greed can inspire an investor to overweight—relative to his/her time horizon and tolerance for risk—a given sector, or equities in general. Typically, and ironically, times of investor euphoria (think tech in the late 90s and real estate in the mid 00s) have tended to be ideal times to rebalance out of equities.
Maintaining an asset allocation/rebalancing strategy keeps one from succumbing to the herd mentality. And, as we’ve discovered, following the herd is generally not your recipe for long-term success—think tech in the late 90s (irrational exuberance), the subsequent market bottom in March 2003 (extreme panic), and real estate in the mid 00s (irrational exuberance), and the subsequent market bottom of March 2009 (extreme panic). I suspect the holders of long-dated bonds have yet to learn that painful lesson.
The Bottom Line – economically, and societally, speaking
While there’s plenty in terms of geo-political risk to concern ourselves with at present, the future holds as much promise today as it has at any time in history. Yes, mistakes, particularly mistakes of policy, will be made. And yes, such mistakes will deliver hurdles and setbacks in the years to come. And yet future generations will witness the advancement of the human condition in ways we can’t even begin to imagine. The ultimate pace of that advancement will be determined by the extent to which we possess the freedom to pursue our individual objectives, and the freedom to conduct business in the global marketplace going forward.
Near-term, I remain cautious. Long-term—bumpy roads notwithstanding—I remain wildly optimistic. That (long-term wild optimism) said, your portfolio must, at all times, reflect your time horizon and your temperament.
Thank you so much for taking the time to take all this in. And I must say what my staff and I say all the time around the office: We have been truly blessed with a most wonderful group of clients! Thank you for allowing us to lighten the burden of investing your long-term assets from your shoulders!
Your financial peace of mind is of the utmost importance to us. So please, never hesitate to call on us---no need to ever wait for our scheduled review meeting---if the uncertainties of the financial world happen to distract you from the things you love to do...
HAPPY NEW YEAR TO YOU AND YOURS! Marty