Monday, June 17, 2013

The Road Taken

by Matt Malick and Ben Atwater

“Two roads diverged in a wood, and I – I took the one less traveled by, And that has made all the difference.”  -From The Road Not Taken, Robert Frost, 1916

In the spring of 2011, inflation expectations were high with commodity prices soaring and gold spiking.  At that time, Federal Reserve Chairman Ben Bernanke described these inflationary forces as transient.  Not too many people believed him.

A large number of diversified investment managers that implement a tactical asset allocation strategy increased their exposure to commodities - an inflation hedge - around this very time.

The 2011 drift to “alternative investments,” mainly commodity-centric ones, has been a regrettable asset allocation decision for many managers.  The Goldman Sachs Commodity Index has plummeted nearly 20% from its April 4, 2011 near-term high; while the price of gold has collapsed by more than 25% since its August 29, 2011 peak.

As a matter of fact, the overall trend among professional investors to avoid traditional U.S. stocks for the last several years has been disastrous.  Not only have managers emphasized commodities as an alternative investment, but they have also stressed “less volatile” vehicles because of an innate fear of markets.  Lo and behold, the experts largely abandoned the most conventional investment vehicle at the wrong time.

Through the end of May, the Standard and Poor’s 500, an index of essentially the largest U.S. companies, has gained an average annual return of 16.87% over the last three years.  Compare this to the aforementioned Goldman Sachs Commodity Index (energy, agricultural, metals, etc.), which returned just 4.79% annually over the same period.

Furthermore, the Hedge Fund Research International Fund Weighted Composite Index, a measure that includes about 2,200 constituent hedge funds of all varieties, returned 5.03% per year over these three years.  This is astonishing only in that a passive group of seemingly pedestrian stocks dramatically outperformed countless MIT PhDs and Harvard MBAs running hedge funds.

At the root of the mistake of underinvesting in the most traditional of asset classes (U.S. stocks) lay both sophisticated and simple reasoning.

Most basically, many investment managers looked at which asset classes performed the best in the five years prior to the financial crisis and assumed this outperformance would continue indefinitely, leading them to hedge funds, emerging markets, international bonds and commodities.  This analysis lacked the intellectual firepower of the most sophisticated asset managers, but the conclusions were the same.

The complex reasons for a forecast of below average U.S. stock performance stemmed from five major themes, all interrelated, that have yet to manifest themselves.  In our view, most major asset management organizations held these opinions and, as such, these views were the consensus forecast.

First, an expectation of inflation, and the repositioning of portfolios to reflect this anticipation, is the leading spoiler of investment performance for broadly diversified wealth advisors who implement a tactical asset allocation strategy.  After much fretting over central bank money printing – Bloomberg calculates that there have been 511 easing actions by central banks since June 2007 – inflation has yet to materialize.

Subdued inflation has allowed the United States Federal Reserve to keep short-term interest rates at 0%, while also purchasing $85 billion a month in long-term Treasury bonds and mortgage paper to suppress rates.  The ten-year Treasury bond pays 2.161%, while a thirty-year mortgage fetches 3.53% - extraordinarily low rates.  Therefore, the second prediction, which is part and parcel with the first, was that the Fed would not be able to maintain its amazingly accommodative policies this long, but they most certainly have.

Because most thought inflation would occur by now and because they then surmised the Fed would need to raise rates (stocks are less attractive as bonds pay more interest), experts have been broadly bearish on stocks.  The third mistake then, rather than allocating more dollars to stocks, managers have instead pushed more and more money into alternative investments, which have lagged core U.S. stocks significantly.

Ordinarily such low interest rates and a highly accommodative Federal Reserve would typically result in a weak dollar, the fourth common prognostication.  But, thus far, the dollar has strengthened - and markedly so over the last six months.  As a result, foreign stocks and commodities (because you can buy more of them with fewer dollars) have been laggards.

And finally, the fifth misstep was the assumption that slow U.S. economic growth would result in lackluster stock market returns.  Although seemingly logical, in reality there is little correlation between gross domestic product (GDP) growth and stock market returns.  With the United States consistently delivering below-trend economic growth over the last three years, the U.S. stock market has produced above average returns - much of which the Federal Reserve has made possible with its aggressive actions.  This takes us back to the first mistake . . .

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