The inglorious exit of Bill Gross from PIMCO, the firm he founded and built into the largest bond management firm in the world, prompts reflection. Gross is almost twenty years my senior, but like him I began my career in a different era. It was the summer of 1982 and the Prime Rate (the rate banks charge on loans to their best customers) was 16%. The inflation rate for the previous three years had averaged 12%. For much of the next 30 years, investment returns would be largely driven by the phenomenon of falling inflation and interest rates.
This backdrop of falling yields had a profound impact on portfolio management. Adding bonds to an equity portfolio was like a magic elixir. Bonds have had an average annual return greater than 7%, and they have been a safe haven during times of crisis. So an allocation to the “safe” asset class was almost an investment free lunch – enhancing returns and reducing risk. The bond market was so powerful (meaning rising or falling interest rates) that James Carville, Bill Clinton’s advisor, once quipped he wanted to be reincarnated as the bond market so “you can intimidate everyone”. But that era is gradually going to come to an end, and relying on bonds for return will no longer be a useful investment strategy.
Recognizing investable trends and shifting a portfolio in the right direction is the key to outperforming a static index. Bill Gross wielded brilliant trend spotting skills for four decades. In 2007 his $220 billion Pimco Total Return Fund outperformed 99 percent of its peers. But even a guru can be out of step periodically. This year his fund was in the bottom 20% of its peer group.
Besides falling interest rates, what have been the trends of the last 15 years and what are we watching currently?
Each period is influenced by that which preceded it, and it is not always easy to determine when one period begins and another ends. Market cycles are commonly defined by periods between recessions, or by bull markets and bear markets.
|Period||S&P 500 Return|
|8/00 – 3/03||-43%|
|3/03 – 10/07||+103%|
|10/07 – 3/09||-49%|
|3/09 – 9/14||+188%|
There have been several distinctive investment periods over the last fifteen years. Two bear markets and two periods of prosperity and economic growth.
2000 – 2003
The 2000 – 2003 bear market followed the tech bubble that led to stocks becoming significantly overvalued in the late 90’s. The three year bear market was a valuation correction. This was especially true for technology stocks, but even companies like General Electric were trading at 30 times earnings. Today GE is valued at 14 times forward earnings. So, one of the key variables for the years 2004 to 2007 was valuation. The strategy for the bear market was to focus on value stocks, hold extra cash and bonds, and avoid technology stocks. Because this was a long bear market, it was possible to shift a portfolio strategy and outperform; however, it was important not to be too bearish. When the market turned in March 2003, it went straight up, gaining 35% in 9 months.
2004 – 2007
2004 followed that explosive move, and the market peaked in January. We then had a series of corrections and a period of consolidation. It was an election year. The stock market is not Republican or Democratic. There are plenty of investors on both sides of the aisle. But investors are uneasy with change, so the market trended sideways in 2004 until November when the election results became clear. The entire gain for the year was made in the final two months. Could 2014 be similar?
China began growing so fast in the early 2000s that it changed the entire global economy. The demand for commodities, as just one example, led to rising prices for everything from copper to oil and lumber. This created a boom for the emerging market economies and for commodity rich countries such as Australia, Canada, Russia, and Venezuela, resulting in a tremendous gain in emerging markets stocks. From 2004 through 2007, the emerging markets index was up 214% and the Europe Australia Far East (EAFA) index was up 92% compared to 42% for the S&P 500. For balanced portfolios, international investments were a significant boost to returns, and especially if they included emerging markets.
At the same time, the U.S. economy was being artificially supported by the booming real estate market. The combination of lax regulation and easy money set the stage for a tremendous bubble. Of course, the bubble burst a few years later. You can imagine the homebuilders and the finance companies did very well during the boom and fell the hardest during the bust.
To summarize, the outperforming areas of the market from 2005 to the market peak in 2007 were emerging/international market investments, commodities and commodity producers, and U.S. housing related businesses including banks and financial companies. For investors, it was also important to pay attention to valuations; and finally it was critical that you got invested. Many investors were too pessimistic following the 2000- 2003 bear market and were too late to get back in to the market. If you were in the market, it was possible to identify and capitalize on these trends as they took a while to unfold. Our clients’ portfolios generally had positive relative performance over this period because we were in the market early, and we identified several of these trends early enough to get on board (such as commodities and emerging markets).
2007 – 2009
From September 2007 to March 2009 the stock market fell about 50% – one of the worst falls ever and most of it happened over a very short period. Our economic and financial system was as close to collapse as it has ever been. There were a few people who anticipated this and capitalized on it; but very few. The ONLY safe haven was U.S. Treasury bonds. This was a difficult time to find outperformance because it unfolded so quickly, but on a relative basis disciplined asset allocation softened the blow; and a reduced allocation to financial stocks, a higher cash level, and a focus on valuations reduced risk in portfolios and helped outperform comparable benchmarks.
2009 – 2014
Since the crisis, the market has been defined by “risk-on / risk-off” periods. It has been a good overall market, but it has been punctuated by a few periods of sharp corrections in stock prices. One difficulty has been to stay fully invested when confronted with so many significant risks, such as the potential collapse of the Euro, unprecedented monetary policy, record unemployment, stagnant growth in Europe and Japan, and slowing growth in China. Plus rising unrest in the Middle East and Russia/Ukraine, and a political system in the U.S. that has been ineffective.
2009 to 2014 has also seen a reversal of many of the trends from the prior five years. For example, while the S&P 500 is up 140%, the EAFE index is up only 70% and the emerging markets index is up 65%. Bonds have returned only 28%. So the normally wise strategy of diversifying has only detracted from returns and added volatility.
This Year. 2014.
Normally, when investment professionals talk about the “market” they are referring to the S&P 500, and it is generally a good reflection of what is happening. This year, that is not really the case. Consider the following index returns (year to date through September 30):
S&P 500 8.3%
Dow Jones Industrials 3.4%
Russell 2000 Small Cap -4.4%
EAFE International -1.4%
The “average” stock has not done nearly as well as the S&P 500 return implies.
Fewer and fewer stocks are driving the performance of the S&P 500. More than 85% of large cap mutual funds have lagged their benchmarks this year.
This is reminiscent of the late 1990s when a small number of stocks drove returns, and there is no discernible theme. It has become more and more difficult to outperform passive indexes as shown in this chart. The market’s return is being driven by a smaller number of mega-cap stocks. Active managers are typically underweight mega-caps relative to the indexes.
Many investors do not understand this. Consider the following example, two investors own the same 5 companies, but with different weights:
|Total Portfolio Return||10%||23%|
The S&P 500 and most indexes are weighted by the size of the company. Exxon or Apple equal about 2.5% of the index return, and Urban Outfitters equals about 0.02%. That means the return of Apple has 125 times the influence on the index return as Urban Outfitters does.
2014 is also turning out to be a year of consolidation, which is normal after the gain of 30% or more in 2013. A company like Amazon, for example, was up 56% in 2013 and is down 18% this year. Since the beginning of 2013, it is still up 28%. Many companies we follow are going through this process. The companies’ fundamentals are fine, but the market prices are going sideways or down in order to digest the outsize gains from last year. This also explains some of the underperformance of small caps and high yield bonds.
Going Forward – How will this cycle play out and what should be the strategy?
- The story hasn’t changed. The U.S. is doing better than you feel. GDP is continuing to grow. Unemployment continues to fall. Demand for commercial and industrial loans is rising and capex spending is expected to rise. Banks have plenty of liquidity to increase lending. Low gasoline prices will boost consumer spending. As shown in the chart on the left, global GDP is estimated to increase from.5% to 1.4% from a drop of $25 in oil prices. Europe and Japan’s economies are sluggish and China’s is slowing. There are a number of issues they have not yet addressed, such as their banking systems, and in China excessive speculation in housing. But even a recession in Europe is unlikely to create a global recession as seen in the chart on the right.
- Interest Rates. Looking at the history of interest rates, this period appears similar to that following the Great Depression. T-bill rates were below 1% for more than a decade from 1933-1948. As rates gradually rose in the 1940s and 1950s the return on bonds averaged only 1.8% for 20 years. The Fed is likely to keep short term rates unchanged for 2-3 more quarters, and then gradually start raising them. It appears they are following the playbook from the period following the 1930s. Inflation is low and not expected to rise any time soon. Using inflation protected bonds (TIPs) as a guide, the bond market is expecting inflation of about 1.5% for the next 5 years.
- Stock Market. How will the stock market react to gradually rising rates? History tells us not to expect the bull market to end at the first increase in rates. It has generally taken 6 months to a year for restrictive monetary policy to begin slowing the economy and the stock market to peak. Based on the historical timeline, the economy and the stock market should have one to two years of growth ahead, but we are getting closer to that eventual peak and we need to be vigilant in watching for excesses created by this zero interest rate policy. Equities are entering their strongest seasonal period. November to May is the best part of the year, and especially so after elections.
- Looking ahead, one thing seems certain, volatility will increase. The stock market’s volatility over last few years has been half its historical level. This has started in October. Equity market corrections like we have seen this month have typically occurred more frequently than we have seen recently. Historically, there have been three corrections per year greater than 5%, one greater than 10%, and one every three years greater than 20%. However, through October 3rd, 2014 we had gone three years without a correction of at least 10%.
These observations lead us to believe that the stock market corrections we experience will be temporary, even though they may be deeper and more common than we have seen over the last three years. Our asset allocation targets have changed little since the start of the year. We remain defensive in bonds (underweighted and shorter average maturities). The risk / reward calculation does not favor longer term bonds, even though we recognize rates have stayed lower for longer than we anticipated. We reduced small cap allocations by a few percentage points this year and increased international. Neither sector has done well, and we will continue to analyze these sectors.
We know we cannot predict with confidence the short term direction of the market, but we will try and protect clients from major bear markets with asset allocation changes within pre-defined ranges. It is a difficult task as markets move very quickly, and for those focused on short term performance it is inevitable you will be either early or late. We are especially alert now after the two major bear markets of the past 15 years, and lingering risks still in the financial system. But, we currently believe it is too early to take a defensive stance and will continue to maintain our asset allocation targets.
We can control the stocks, bonds, and managers in our portfolios, and we can manage expected risk levels in the portfolio through diversification. This becomes a discussion each investor needs to have with his or her Advisor, as volatility is more acceptable to some than others. For the stocks, bonds, and mutual funds in clients’ portfolios we are researching them daily. We recognize the outperformance of indexes currently, and may move more assets into them. This cycle too will change, however, so we do not want to unnecessarily incur taxes or trading costs. In the investment business, it is foolish to offer guarantees; but the one thing we can guarantee is 100% effort, every day, working on your behalf.