The Morning After …
February 28, 2007
Following Tuesday’s dramatic drop in global equity markets, we feel it is important to offer our two cents. By now it is likely many of you have read or heard some commentary by a market analyst, strategist, economist, or reporter on Tuesday’s events. Perhaps even your mail courier or contractor has chimed in. So it is true we could be flagged for piling on at this point. Nonetheless I think Tuesday’s sell-off is an excellent opportunity to reiterate some long-standing philosophies we attempt to employ in guiding investment portfolios:
1. Asset Allocation Matters – Holding a portfolio of multiple asset classes leads to less volatility and higher riskadjusted compounded returns. This conclusion is reinforced time and time again. While it is easy and tempting to think you should be 100% in equities when a bull market rally is raging and 100% in cash when the market does a swan dive, the chances of those all or nothing changes delivering sustainable out-performance are nearly zero. While it is true that in strong stock rallies like we witnessed over the past eight months, a diversified portfolio may underperform a 100% stock allocation but the diversified portfolio came out ahead after yesterday’s action.
2. Selling Into Strength, Buying On Weakness – Generally speaking we attempt to keep portfolio turnover to a minimum. This helps to avoid unnecessary taxes and transaction costs. However, when certain investments or asset classes have enjoyed strong performance and are at levels we believe to be unsustainable, we have experienced better success trimming or eliminating the investment during periods of rising value while looking to add to positions when price levels drop to more reasonable levels - the old “buy low, sell high.” Of course this is easier said than done. Parting company with an investment that has increased your net worth is often hard to do but for persistent investment success it is highly important. Taking profits and re-deploying the money to a more compelling asset class or investment prepares your portfolio for the eventual rainy day.
3. Looking for Relative Value among Asset Classes – Going hand-in-hand with point number two is our on-going effort to find relative value among a number of asset classes. We do this not only to improve returns but to manage risk as well. Under our approach, rebalancing a long-term portfolio is driven more by risks and opportunities than by the turning of a calendar. While there is nothing wrong with adjusting your asset class allocation on a regular interval we prefer an approach that takes into consideration the current state of affairs in the financial markets. So when stocks look over-valued relative to bonds or other asset class or vise-versa we make changes. Sure it can be difficult to invest in something that has not been working by selling something that has but it is this discipline that keeps the ship on course.
4. Sometimes Holding Cash is the Best Decision – Generally speaking for long-term portfolios minimizing the cash holdings is the best decision over time. However, with new money to put to work or after an extended rally sometimes the opportunities to invest are limited. In those situations it is helpful to “keep the powder dry.” Chasing performance is never a good thing. Over the years we have learned this lesson time and time again. Knowing what you are willing to pay is as valid a concept in the financial markets as it is when you are buying a new car or new winter coat. Patience is needed but the results can be worth it.
5. Remain Focused on the Long-Term – In our increasingly “hyped” world it is easy to get caught up in the daily news cycle. The media, in their effort to draw attention and, consequently, advertising dollars, can go over-board with any issue (Anna Nicole Smith for example). All of this hyperbola can be disastrous for any investor. One day everybody is upbeat and confident and the next downbeat and crying wolf! When you look at history you see that time has overcome many issues that at the height of their attention could have lead investors to bail. Admittedly, I sit here today looking at the growing threat that is Iran and the difficulty we as a nation are having deciding how best to deal with the issue and I wonder what the future holds. I’m sure investors in previous eras have thought the same about their big issues. Aside from (hopefully) just a few radicals around the globe the majority of humans awake each day to go about the business of improving their lives and that of their children and it is this drive and the march of liberty around the globe that keeps me positive over the long-run.
With those points made it is naïve to think that Tuesday’s sell-off was not significant. It certainly was. For those of you who participated in our last conference call or downloaded our presentation from our website you will note that we talked about the technical weakness of this market. In lay person’s terms that simply means that the intensity of buying was waning while the intensity of selling picking up. I could go on for pages about technical indicators but I’m sure it might bore you to tears so the important point to note is that we follow the indicators and many were flashing warning signs over the past month or so. In the long run financial markets are driven by economic fundamentals but in short periods of time they are driven by emotions. One thing I can confirm with near 100% certainty is that the boom-bust cycle of free market capitalism has not ended nor will it. During the past 45 months we have not seen a one-day sell off of more than 2% on the S&P 500. That is an unprecedented run considering that over the past 70 years one day drops of 2% or more have happened on average eight times a year. As you might suspect this run lead to a meaningful dose of complacency in the market and all that goes with it: more use of leverage, increasingly larger mergers and acquisitions, unwise lending and increasingly aggressive risk appetites. Unfortunately history shows us that these parties end and often suddenly.
So where do we go from here? Given the debate that had already been raging at the ground level between the soft landing optimists and the hard landing pessimists it is doubtful one day will settle the score. We have been commenting that the returns in financial markets in 2007 will depend on a continuation global economic growth, solid corporate revenue and earnings growth, capital spending and a firm labor market while avoiding any major unpredictable exogenous events (terrorism, natural disaster, etc.) all without rising inflationary pressures. Valuations overall were and remain fair (except for a few asset class, U.S. real estate trusts and high yield bonds come to mind) and interest rates remain historically low. Believing all of those criteria to be true a case can be made for positive returns this year but needless to say that is a long wish list. In contrast, we have also made note of a number of dark clouds on the horizon that could quickly change the course: the weak housing market, the vulnerability to energy supply stocks, decelerating earnings growth, tightness in the labor market and the newest perhaps most concerning of them all - rising delinquencies among sub-prime loans. My experience tells me that we are likely to see more turbulence in the immediate future until some of these issues work themselves out and / or asset prices drop to more attractive levels inducing buyers back into the market. Will this take a week, a month, a quarter or two? Hard to say but my gut is saying it might be a least a few weeks and more likely a few months.
I will close by commenting as I have in the past: The allocation strategies we have recommended for your investment portfolio are based on your risk tolerance, return objectives and investment horizons. They utilize multiple asset class (stocks, bonds, cash, real estate, precious metals, commodities and other alternatives including hedge strategies and private investments, etc.) that are not 100% correlated, allowing the returns to be optimized on a risk-adjusted basis over time. Bad days, bad quarters, and bad years will occur; staying the course and rebalancing when opportunities present themselves are essential to long-term success. The critical question you need to ask yourself is whether your long-term risk tolerance, your investment horizon, or your ultimate return objectives have changed. If they have it is important we meet to discuss them. Otherwise we need to remain steady through the storm.
Jack E. Payne, CFA
Chief Investment Officer & Senior Strategist