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.

Wednesday, October 16, 2013

UPDATE: Washington Woes

  by Matt Malick and Ben Atwater

“Politics is the art of looking for trouble, finding it whether it exists or not, diagnosing it incorrectly, and applying the wrong remedy.” Ernest Benn

“Politicians are like diapers.  They both need changing regularly and for the same reason.” Unknown

The continuing government shutdown and the impasse over the debt ceiling make this a stressful time for investors.  Particularly frustrating, as investment managers, is the impossibility of handicapping political martyrdom.

That said, our most likely scenario is that moderate Republicans will persuade Speaker Boehner to bring a “temporary” debt ceiling vote to the House floor.  Many believe that a majority exists in the House to pass such a measure today.  This legislation would likely be a stopgap measure to include a side agreement for future talks.  Over the last few days, Speaker Boehner’s camp seems to have delinked Obamacare from the debt ceiling debate, recognizing it is a political loser.  So future negotiations will probably be linked to entitlement reform and other spending reductions.

However, we believe that investors have been too sanguine about a resolution to this political drama.  There is no reason to think that President Obama and Speaker Boehner won’t go to the 11th hour.  We would not be surprised to see heightened market volatility next week.

From its September 18, 2013 closing high of 1725.52, the Standard and Poor’s 500 Index fell just 4.2% as of Wednesday’s close, before rallying aggressively Thursday and Friday.  From a contrarian perspective, we would frankly prefer to see the market a little more panicked at this point . . . In a way, the equity market seems to be giving Washington the benefit of the doubt.  Perhaps investors concur with Winston Churchill, who once said, “Americans can always be counted on to do the right thing . . . after they have exhausted all other possibilities.”

Maybe investors are also remembering that we have seen this movie before.  In July of 2011, Obama and Boehner brought us to the brink of default over failed debt ceiling negotiations, resulting in a drop of 20% in the S&P 500 and also in Standard & Poor’s downgrade of U.S. sovereign debt from AAA to AA.  When the smoke cleared, markets recovered quickly.

Another possible factor behind the market’s complacency is that the consequences of default are so unthinkable that it is difficult to contemplate such self-destruction by our leaders.  But investors may be a little too comfortable with this consensus view.  Politics has become a narcissistic profession and stubborn pride could lead to great harm.

That said, despite dangerous ideology and extreme arrogance, we are cautiously optimistic that sense will prevail over mutually assured destruction.

At the height of the last debt ceiling crisis on July 26, 2011, we wrote to you that:

“Our highest probability scenario is that the government will act “in time” to raise the debt limit (a peculiar necessity considering Congress made the expenditure and revenue decisions which created the structural debt to begin with).” 

The atmosphere in Washington seems even more poisonous now that it was then.  However, given the backdrop of a financial crisis, a completely dysfunctional government and a sluggish economy, some amount of good news over the next few years should fuel additional interest in capital markets.  But, such frequent self-induced crises are enough to dampen our enthusiasm.

That said, frustration aside, we see an ultimate resolution to the crisis du jour.  Now is not the time to make rash investment decisions.  Nothing fundamental has yet changed and as a result we still believe that patience will reward investors who stick to their discipline (as has always been the case).