On June 5th, 2009, the economist and author Peter Bernstein passed
away. Bernstein was one of the great investment professionals of the
modern era. Not only was he accomplished in the practical aspects of
investing, but also in his ability to explain with simplicity, theoretical
aspects of investing to both his professional peers and the public.
Professionally, this may have been his greatest gift.
Many of the obituaries on Bernstein, when they discussed his
professional achievements, emphasized that he was a proponent
of efficient market theory (which suggests the markets are coolly
rational and informationally efficient). Personally, I feel
that this emphasis was misplaced, as I believe his major contribution
rested more directly with the theory of portfolio management,
including the need to diversify and manage risk.
Bernstein had many notable sayings. Here is one I saved from
earlier in the decade in an attempt to defend balanced portfolios
against the common demand of the time -- many investors
wanting all-equity portfolios. Now, of course, we are arguing
against all-bond portfolios!
"Your future wealth isn't a game. …Investment
management provides only one dependable way to survive through
the uncertainty of the future: diversification. Diversification
means owning assets that do not move up and down together — a
portfolio destined to subdue volatility rather than to maximize
returns, while still exposing you to the widest possible range
of positive opportunities. (A colleague once suggested you are
never adequately diversified unless you have some holdings that
make you uncomfortable.) ...I propose restoring the 60/40 to
its rightful place as the center of gravity of asset allocation
for long-term investors. "
-- Peter Bernstein Bloomberg Personal Finance Jan/Feb 2002
I saved this comment for its various nuggets of wisdom. Not
only did Bernstein address the uncertainty of the future (always
a good reminder), he stated that the best practice for long-term
investors dealing with an uncertain future is to maintain balanced,
diversified portfolios. His proposal that the classic balanced
portfolio of 60% stocks and 40% bonds/cash as the center of
gravity for asset allocation is also a crucial point. We also
believe that this is a good starting point for many investors
though, of course, asset allocations should be modified depending
on each investor's unique situation. These factors include
investment objective, time horizon, and risk tolerance as well
as market outlook.
Thank you Peter. May you rest in peace.
Can The Rally Continue?
Peace, however, is not something that the markets have provided
for investors thus far in 2009. Despite an overall price return
of approximately 2% for the S&P 500 at mid-year, the index
started the year with a 25% loss before rebounding 36% by
the end of June. Never mind these dramatic multi-month moves,
the intra-day, daily and weekly price moves have also been
quite dramatic. In short, given the strong economic cross-currents
still in place, we expect that the markets will remain bumpy
in the months ahead with plenty of big swings. Peace will
remain in short supply.
This volatility has kept many investors on edge and disbelieving
of the market's recent gains. The question on everybody's
mind: "Can the rally continue?" is usually quickly
answered with a skeptical response. In fact, most investors
remain quite bearish and defensive.
We like to consider ourselves skeptics as well, and despite
the S&P's best calendar quarter in over a decade,
our outlook for the stock market remains mostly positive. It
isn't so much that we are raging bulls -- market
prices and valuations are up substantially off the lows from
March -- we just think there are solid reasons to not be
negative. Even though a short-term market correction would not
surprise us, we do not think the rally is in its last innings.
In this report, we'll explain why. We will also explain
our thinking on a few key market exposures that have shaped
the positioning of our portfolios. This includes international
markets, larger-capitalized domestic stocks, as well as corporate
bonds in the fixed income world.
Corporate Earnings
Earnings expectations have improved in recent months. Operating
earnings are now expected to improve 12% in 2009, while reported
earnings growth are now projected to nearly double the 2008
numbers. While the absolute level of corporate earnings is
still at levels from 2002/2003, the trend has clearly improved.
We see an interesting conflict in corporate earnings which
we think may be another indication of an economic trough. Currently,
there is a large divergence between reported earnings and operating
earnings. Generally, these two earnings measures move closely
together (reported earnings are usually about 90% of operating
earnings), but they have a tendency to diverge during recessionary
periods. (One reason is that corporate executives often pile
on negative extraordinary charges during market environments
where expectations are already bad.) The good news is that such
divergences in the past have usually been resolved by reported
earnings "catching up" with operating earnings.
The chart (next page) highlights two key points we just made:
(1) earnings expectations are improving, and (2) the dramatic
divergence between reported and operating earnings.
In addition to the points made above, there is still a strong
possibility that earnings could even be better than the consensus
expects. Analysts tend to be too optimistic regarding their
earnings projections, but this is not usually the case around
economic troughs. If the economy is exiting a trough, then the
actual path of earnings on the chart (next page) a year from
now could look even more dramatic than it does now.
Valuations
On balance, valuations remain mostly attractive. Let's
look at the price/earnings (P/E) ratio, which is arguably the
most common valuation metric used.
There are various ways of computing a P/E ratio. Some use operating
earnings while others use reported earnings. Some use historical
earnings, or expected earnings. Some use a year's worth
of earnings data; some use multiple years' worth of earnings
to "normalize" earnings. This is why one might see
vastly different P/E ratios at the same time for the same market.
It depends on the analyst and how they compute the ratio.
Our preference is to normalize the earnings number. We feel
that this provides more reliable and smoother input in forming
an opinion about whether or not the market is attractively priced.
A good reason for this is that P/Es often provide vastly distorted
signals at economic inflection points. For example, when corporate
earnings are weak, P/Es are often elevated as the denominator
is depressed. This would suggest that the market is expensive,
when actually it may be an excellent time to increase exposure
to stocks since an economic recovery appears imminent. Conversely,
when corporate earnings are peaking, P/E ratios may be lower
as the denominator is now inflated. Again, this may suggest
that the market is cheap, but in actuality, it may be expensive.
In short, normalizing earnings takes care of most of these issues
by looking at earnings over an economic cycle.
Currently, the normalized P/E ratio is approximately 15 times
earnings. This is well off the multiple of just over 10 times
back in early March, but it is also well below the 50-year median
multiple of roughly 20 times. If the stock market was able to
get back to its longer-term median -- admittedly, this
usually takes years to do -- this would take the stock
market back (assuming no earnings growth) to approximately the
level the market was at before selloff that began last September.
Before moving on, there are a couple of more questions about
valuations, which we often receive, that need to be addressed.
First, what is a "fair" long-term multiple for earnings?
Debates have been waged and papers have been published on this
topic, with no decisive answer. In general though, there is
some consensus about what conditions are needed for valuations
to be higher or lower. For instance, when there is price stability
in the economy (in other words no significant inflation or deflation),
valuation multiples are higher. Second, when costs are lower -- transaction
costs, taxes, or the even the costs of attaining quality information -- valuations
tend to be higher as well. Related to both of these points about
inflation and costs, is the level of interest rates. When rates
are low in an absolute sense, then valuations again tend to
be higher.
So, where do we stand today? While there are clear threats
to price stability, costs, and interest rates -- then again,
there always are -- in an absolute sense, current conditions
would suggest valuations should be higher than long-term averages,
not lower.
Second, how effective are valuations in forecasting stock market
returns over a variety of time frames? While we have often stated
that valuations are a powerful driver of returns over periods
of 10 years or so, they do appear to have some predictive power
for time frames as brief as a year. In sum, when valuations
appear cheap on an historical basis, the market tends to produce
above-average returns over time frames of 1-year, 3-years, 5-years
and 10-years. And, when valuations appear expensive, the market
tends to produce below-average returns over the same time frames.
Sentiment
Typically after market rallies, investor sentiment follows;
this has not been the case so far this year, which is encouraging.
Perhaps the rally could still have legs. As the late Sir John
Templeton said: "bull markets are born on pessimism,
grow on skepticism, mature on optimism, and die on euphoria." It
could be argued that the current emotional backdrop for the
market is still pessimistic, skeptical at best.
At the end of the quarter investor sentiment was registering
excessive pessimism. Excessive pessimism is defined as over-all
sentiment being at least one standard deviation below the long-term
average. Historically, when sentiment is this negative, the
market tends to produce above-average returns in the following
3-, 6-, and 12-months.
Sentiment isn't just about what investors say, it's
also what they do. Perhaps an even more powerful signal is that
money is finally emerging from cash accounts and moving back
into the markets. We don't have data for June yet, but
the month of May witnessed the largest monthly inflow into mutual
funds ever. Is the tide starting to turn? If so, it may be useful
to remember that there is still a tremendous amount of cash
still on the sidelines, potentially representing a considerable
amount of buying power that may eventually want higher returns
than what is currently being earned on short-term money.
Liquidity
Speaking of money flows and liquidity, this picture remains
mostly positive as well. When we assess liquidity -- which
generally means we are attempting to assess supply and demand
in the marketplace -- we look at a variety of indicators,
ranging from monetary policy to the technical condition of
the market. Inter-market relationships also provide an indication
of overall market liquidity.
One inter-market relationship we have often written about is
the TED Spread. The TED Spread is the difference between interest
rates on interbank loans (LIBOR) and short-term U.S. government
debt (Treasury Bills). A higher level for the TED Spread suggests
that liquidity conditions are tight while a lower level suggests
more normal conditions.
As can be seen by the chart (previous page), the TED Spread
has continually improved all year and is now back at levels
before the panic-induced sell-off from the Lehman bankruptcy
back in September 2008. The current level of approximately 0.4%
is even below the 15-year average of 0.6%. This would suggest
the liquidity conditions have improved enough to temper concerns
about credit risk; in turn, this should continue to restore
the demand for riskier assets.
Given the points above, matched with positive second half of
the year seasonal factors and a supportive interest rate environment,
it would appear the stock market has the potential to extend
its second quarter gains into the second half of 2009.
Now, what market areas should be emphasized?
International
International markets continue to generate a lot of investor
interest, and for good reason. Not only do non-U.S. economies,
in the aggregate, appear to offer higher economic growth potential,
but they also had a great first half of the year in terms
of price returns.
Despite the strong absolute and relative gains in international
markets last quarter, we are maintaining (and in some cases
even modestly increasing) exposure to international markets.
This view is driven by relative valuations. The easy story at
present, as it has been for awhile, is Asia (outside Japan),
but it's important to remember that Europe and Japan make
up approximately 75% of the non-U.S. stock market -- and
they are cheap.
Currently, Europe (ex-U.K.) and Japan are sporting relative
valuations compared to the U.S. that are similar to earlier
in the decade before international markets began a pronounced
multi-year run of significant outperformance versus the U.S.
To re-state, investing in international markets is not just
about the emerging markets and the Asian story, it is about
all international markets. So, how much should investors have
in international investments? In our opinion, a good rule of
thumb regarding over-all portfolio exposure levels to the international
markets for a U.S. based investor is approximately 20%. This
includes both international stocks and bonds. This 20% investment
weight approximates the amount the average American consumer
spends on non-dollar goods and services. Investors should have
at least this much exposure to international.
Large Caps
When it comes to domestic stocks, we have been advocating increased
exposure to large cap domestic stocks for several years. As
the chart (next page) shows, we have had some satisfaction
with that view, but not as much as we would have guessed -- especially
given the markets over the last few years. Nonetheless, we
are maintaining that view.
There is a combination of reasons we prefer larger companies,
beyond the appearance that large caps appear to be 25% undervalued
to smaller companies by referencing the relative price performance
over nearly the last 15 years.
Our primary attraction to larger companies is due to relative
valuations. Using data from The Leuthold Group that goes back
to 1973, small cap stocks typically trade at roughly a 15% discount
to larger companies. Currently, however, they trade at a small
premium. In other words, larger companies appear even cheaper
than smaller companies do.
Yet another reason we are attracted to larger companies is
that they are under-appreciated and under-owned. As a frame
of reference, large capitalization stocks make up over 70% of
the stock market in terms of total stock market capitalization.
Most investors have less, sometimes significantly less, exposure
than that, though. This was not only the case coming into the
year, but looking at fund flows through the end of May, large
cap funds have had by far the largest outflows of the year -- well
over 90%.
We do recognize and appreciate the leading argument for small
cap stocks is that they tend to do better in market and economic
recoveries. It's hard to argue against that since this
is regularly the case. That said, small caps tend to lead in
recoveries because they significantly lagged during the preceding
market and economic weakness, thus their starting valuations
are often depressed relative to larger companies once the rally
begins. That's not the case right now. Despite historic
weakness in the markets of 2008, small caps did not significantly
underperform as would have been expected versus larger companies
in such an environment.
Lastly, in an environment where overall economic growth may
be lower than historical averages (due to consumer deleveraging
and more government regulation), it seems intuitive that larger
companies with more stable earnings, larger compliance resources,
and bigger lobbying budgets are also more likely to outperform.
Corporate Bonds
Coming into the year, we stated a strong preference for corporate
bonds, both investment grade and high yield. Both segments
have done well so far in 2009, especially the latter. Investor
interest in corporates has also exploded with much of the
aforementioned record flows into mutual funds going into fixed-income
funds.
Because of the strong gains this year, our enthusiasm is dampened.
Still, we are retaining our current positioning. Spreads between
investment grade corporate bonds and Treasuries, as well as
spreads between high yield bonds and Treasuries, remain well
above long-term averages. While we think there is a strong possibility
that most of the "easy gains" are now behind us
and the road ahead will be choppier, valuations still suggest
that corporate bonds deserve a healthy weighting in client portfolios.
And, while the concern that corporate high yield bond price
gains "have gone too far, too fast" has become a
popular refrain, the historical evidence actually shows something
else. The asset class actually tends to generate above-average
returns in the following 3-, 6- and 12-months (at least double
the long-term average in each time frame) after especially strong
quarters.
How much should one have in corporate bonds? For an approximate
frame of reference, the overall taxable bond market is roughly
25% corporate bonds (including high yield). We believe that
investors should have at least this much exposure, with about
half of the over-all corporate bond exposure in high yield bonds.
Summary
While valuations are no longer as attractive as they were a
few months ago, we are maintaining our optimistic outlook.
Though the stock market has had a nice run in recent months,
an argument can be made that the rally can continue in the
second half of the year. We also recognize that the markets
are likely to remain volatile and thus uncomfortable. But
as Peter Bernstein himself said, the only way to take advantage
of future positive opportunities -- which will appear
as they always do -- is to remain committed to a balanced,
diversified portfolio.
Sincerely,
