Wednesday, July 23, 2014

UPDATE: All-Time Highs

by Matt Malick and Ben Atwater

The stock market has been on a tear lately and the Standard & Poor’s 500 Index is approaching the two-thousand mark.  The current bull market, which began on March 9, 2009, is both the fourth strongest and the fourth longest, rising nearly 194% in over five years.

If it seems like stocks are cracking new all-time highs on a weekly basis, well, they basically are.  Since reaching a new all-time peak on March 28, 2013, the S&P 500 has hit a new record on 21.4% of trading days – more than once a week, on average.

Since its inception in 1950, the S&P 500 has struck new all-time highs on just 6.8% of trading days. But, this long-term average includes weak markets where new highs are rarely eclipsed, such as the period from 2000 to 2013.

The roaring 90s offer an interesting point of comparison.  After attaining a new all-time peak on Valentine’s Day in 1995, the S&P 500 made new highs on 19.1% of trading days up until the tech bubble began to burst in March of 2000.  This frequency is in the ballpark of the current environment.  But, keep in mind, that equities hit new highs on almost a weekly basis for over five years, whereas the current run has lasted less than 16 months.

As the market continues its ascent, we are keeping a close eye on sentiment and valuations.  Thus far, even minor upticks in volatility have led to spikes in bearish sentiment, as measured by various survey data.  From an anecdotal perspective, the financial media, the investment industry and even clients still seem to view this market with a great deal of skepticism.  Not until investors begin to shrug off bad news and view pullbacks as “buying opportunities” have bull markets usually run their course.

And from a valuation standpoint, the S&P 500 trades for about 18 times trailing earnings per share.  While loftier than the historical average, the ninth innings of bull market runs accompany even higher multiples.

While we believe this bull market still has legs, all good things must eventually come to an end.  Therefore, to be prudent, we are continuing to rebalance client portfolios where appropriate.  This involves trimming outsized positions, adding to underperformers and realigning the mix between equities and fixed income.

Monday, May 5, 2014

UPDATE: Bonds as a Hedge

The market has been more volatile in 2014 than last year.  When markets get rocky, many investors look for fancy products to “hedge” their risk.  The reality though is that high-quality bonds are the cheapest and most effective hedge available.

Since the start of the year, the Barclays Aggregate Bond Index (blue line) has been relatively stable and has proved a nice diversifier to the Standard and Poor’s 500 Stock Index (green line).

Over a longer time period, for example the ten years from 2004 through 2013, both stocks and bonds performed well.  Equities (blue line) and fixed income (orange line) returned 7.4% and 6.1%, respectively, compounded annually.  However, as the chart below demonstrates, when stocks did well, bonds tended to lag and vice versa.  And in this example from Morningstar, systematic rebalancing caused a portfolio of half stocks and half bonds (gray line) to actually outperform either individual asset class with less volatility.

Because interest rates are so low, some investors think bonds are a lousy investment.  But while bonds may have limited long-term return potential, they are still a terrific hedge against market volatility.

Fidelity Investments studied a rising interest rate environment from 1941 to 1981 and found that by adding 20% bonds to an all-equity portfolio, volatility dropped by over 20% (standard deviation went from 14% to 11%), while returns fell by less than 10% (annualized total return went from 11% to 10%).

In other words, even when bonds seem like a poor investment on a standalone basis, they can be a smart holding in a portfolio context.  For this reason, it pays to be disciplined about rebalancing.

Monday, January 27, 2014

UPDATE: An Emerging Emergency?

By Matt Malick and Ben Atwater

Stocks were pummeled last week.  Or at least it felt that way.  Given the low volatility and high returns we saw in 2013, this week felt particularly grave.  The S&P 500 fell 2.6%, while the Dow Jones Industrial Average lost approximately 3.5%, its biggest drop since 2012.

The crisis du jour lies in emerging markets.  A Bloomberg gauge tracking 20 emerging market currencies hit its lowest level since April 2009; the index has tumbled almost 10% in the past year, the biggest annual decline since 2008.

More specifically, South Africa’s rand is at its lowest level since 2008, Brazil’s real fell to a five month low and has lost 28% in two years, the Argentine peso is at levels unseen since 2002, the Turkish lira set a record low and Ukraine’s hryvnia is the weakest it has been since 2009 amid violent protests.

After logging a relatively rotten year in 2013, emerging market equities are showing signs of a complete breakdown, losing more than 5% so far in 2014.  As you know, we do not have direct exposure to emerging market stocks, a conscious and, so far, wise decision.

More than $940 billion has been erased from the value of emerging market stocks since the United States Federal Reserve signaled in May the potential to curb its easing policy.  Fund tracker EPFR estimates emerging equity and bond funds have seen outflows of $5 billion this year and nearly $60 billion since the beginning of 2013.  Presently, there is a significant flight of capital from emerging market assets.

Whether or not U.S. equities can continue to withstand a meaningful correction in emerging markets remains to be seen.  Another question on our minds is when we might see a buying opportunity in emerging markets.

For now, the benchmark Standard and Poor’s 500 Index has fallen below its 50-day moving average, which is a poor technical indicator going forward.  Interestingly, though, the S&P is still just 3% below its record closing high.

One bit of good news, of the 122 S&P 500 constituents that have released earnings so far this season, 74% have beaten earnings estimates, while 67% have exceeded sales projections, according to Bloomberg.  The reason we own individual stocks is because the fundamental health of the underlying businesses is the only thing that ultimately matters in the long-term.  The current emerging markets “crisis” is merely a noisy short-term problem.

Thursday, December 5, 2013

UPDATE: The Rest of the Year

by Matt Malick and Ben Atwater

Many clients have been wondering how we see the balance of the year for financial markets.

First, it is important to understand that 2013 has been a tale of two markets – U.S. stocks and everything else.  In contrast to the strength of U.S. equities, nearly every other market, from gold to emerging markets to alternative investments, has seen results ranging from terrible to lackluster.

In 2013, the broadly diversified, or endowment, model of investing dramatically underperformed U.S. markets.  Although we consider ourselves diversified investors, we have been positioned much more in line with what has worked – U.S. stocks.  Therefore, our clients have been particularly successful so far this year.

Although there are no guarantees, the period from Thanksgiving through Christmas has historically been solid for U.S. stocks.  Since 1945, the S&P 500 has averaged a gain of 1.76% with positive returns 71% of the time, according to Bespoke Investment Group.  And, in years where the market is already up 10% leading into Thanksgiving, average returns are a slightly more robust 1.89%.

Bespoke further calculates that in the current bull market, which began in March 2009, the S&P 500 has averaged a gain of 4.41% from the end of Thanksgiving week through year end, with positive returns every year.

The most commonly cited risk to the market right now is the idea that the Federal Reserve could “taper” its quantitative easing program (the purchase of $85 billion per month of Treasury Bonds and mortgage-backed securities in the open market).  Each time the market perceives tapering as a possibility, stocks slide.  We most certainly agree that this is a risk for the market, but we believe tapering is still many months away.

Another potential pitfall for the market is valuation.  Stocks are no longer cheap.  At best, by historical standards, they are now fairly priced at about 16.5 times trailing earnings.  However, in an extended bull market, equities tend to get awfully expensive before valuations correct.  In other words, the stock market usually goes down too much and then up too much.  Unlike Goldilocks, Mr. Market likes it too hot and too cold.

For now, we believe our focus should be twofold:  1) continuing to rebalance accounts to long-term asset allocation targets, which has meant trimming stocks and patiently adding to bonds and 2) looking for stocks that are less expensive than the market, which potentially adds a margin of safety if we encounter a market correction.

Friday, October 25, 2013


By Matt Malick and Ben Atwater

“That’s been one of my mantras - focus and simplicity. Simple can be harder than complex:  You have to work hard to get your thinking clean to make it simple. But it’s worth it in the end because once you get there, you can move mountains.” - Steve Jobs, 1998 Business Week Interview

We have written extensively over the last five years about the effectiveness of a simple, understandable, transparent and low-cost investment philosophy.  The way we invest, 
which we outlined for the first time in September 2008, stems from the discomfort we experienced while watching our industry slip into darkness.  Luckily, our timing could not have been better.

For the five years ending September 30, 2013, the most basic index of American stocks, the Standard and Poor’s 500, doubled the annualized performance of the Hedge Fund Research Incorporated Fund Weighted Composite Index - 10.02% versus 5.01%.  This means that a passive basket of U.S. stocks dramatically outperformed the sophisticated, “go anywhere” strategies that the most brilliant practitioners on Wall Street conceived.

Lately we have fielded several inquiries about alternative investment strategies as a way to manage risk.  It seems to us that despite all the evidence to the contrary, investors are still searching for something that doesn’t exist – a formula to sidestep market losses while also getting a better return than bonds currently offer.

And this impossible quest is not limited to individual investors. The New York Times recently reported that “so-called alternative investments now account for almost one-quarter of the roughly $2.6 trillion in public pension assets under management nationwide, up from 10 percent in 2006, according to Cliffwater, an adviser to institutional investors.”

The Rhode Island pension plan, for example, has increased its investments in alternatives from zero to almost $2 billion, or 25% of its assets, in the last two years.  The result has been poor performance and outrageous fees.  Their investment expenses for the year ended June 30th were $70 million versus a prior estimate of $11.5 million, primary due to alternative investments that charge up to 2.5% annually of assets under management plus another 20% of profits.

In reference to individual stock investing, the legendary Fidelity Magellan Fund manager, Peter Lynch, said, “The simpler it is, the better I like it.”  We think this sentiment applies to investing in general.  You can observe a great example of this in 2008, a terrible year for the stock market, and the ensuing market recovery in 2009.

In 2008, the S&P 500 fell a whopping 37%.  But, interestingly, the Barclays U.S. Aggregate Bond Index actually rose 5.24% that year.  So, if you had a 50% stock and 50% bond portfolio, you would have lost 15.88%.  Not good, but far from devastating.

Then in 2009, the S&P 500 rose 26.46% and the Barclays U.S. Aggregate Bond Index rose 5.93%.  The same 50 / 50 portfolio would have gained 16.20%.  If the portfolio was rebalanced annually, then less than a year removed from the financial crisis and Great Recession, an investor in a plain vanilla balanced portfolio would have almost fully recouped all losses.

Lastly, in 2010, the same 50 / 50 portfolio would have generated 10.8% returns, putting the portfolio back in the black and well-positioned for robust returns in the years since.  (Even without annual rebalancing, a 50 / 50 portfolio would have produced positive three-year returns from 2008 through 2010.)

As evidenced above, risk mitigation techniques do not need to be fancy, overly complex or expensive.  Frankly, in our experience, the more esoteric these schemes, the less effective they are.  Make no mistake, finding the proper allocation to high-quality bonds to complement your stock exposure is the best risk management strategy – it is straightforward, transparent and low-cost.

The chart below shows that even during a protracted bear market for bonds (1941-1981) - a time when interest rates rose and bonds prices fell – they still proved an excellent risk manager.  The standard deviation (a statistical measure of variation around the mean) for a 50% stock / 50% bond portfolio was half that of an all-stock portfolio, or half the risk.


Ignoring the advice of Leonardo de Vinci that “Simplicity is the ultimate sophistication,” many risk-averse investors will buy anything, as long as it sounds sophisticated, regardless of whether they understand it.  Or maybe the fact that they don’t understand it gives a certain level of comfort – if it’s that complicated, it must be good!

The old economic axiom, “There’s no such thing as a free lunch,” provides a cautionary message to people looking to manage risk via magic trick.  Investors are na├»ve to believe strategies actually exist that can consistently shuffle money from one asset class to another with precision, or predict which stocks will spike over the short-term even when the market declines, or that can use options to truly protect against the downside without considerable cost, etc.

The martial artist and movie star Bruce Lee believed that, “It is not a daily increase, but a daily decrease.  Hack away at the inessentials.”  From an investment standpoint, be honest with yourself about what you are trying to accomplish.  Don’t subscribe to the myth that a black box exists that will protect you from high stock prices and low bond yields.  Instead, avoid the temptation to purchase investments that are supposedly sophisticated enough to outperform the tried and true.

A final thought from Peter Lynch: “All the math you need in the stock market you get in the fourth grade.”  This may sound unreasonable, but it’s surely true.  A real investment discipline will outperform all of the gimmicks.