Real Estate and Timing the Rebalance

Since Real Estate is an important asset class in any serious allocation, we are providing this link to a very good article on when to fill one's allocation to Real Estate (specifically via REITs, for anyone whose home equity does not fulfill the allocation).

Historically, they key has been to look at REIT yields versus Treasuries, and buy when the yields are high. While this is naturally intuitive, the article does a nice job laying this out.

China Equity Market Not Expensive If Real Growth Slows Some

We recently increased our Developing Markets exposure slightly -- via Chinese ADRs -- given signs of the world financial system "muddling through" the crisis period. A "muddle through" is the bull case, and the more we muddle, the lower the chance of the "tail risk" of a major melt-down.

We're still underweight equities overall, and Developing Markets equities specifically, because we don't think we're at "the beginning of the end" of the financial crisis yet. (One thing we're waiting for is a Developing Market financial crisis as a sign that the global crisis has come full circle.)

Nevertheless, a bump-up in our Developing Market allocation via China has a somewhat higher reward/risk ratio than it has for a while, we think. A few helpful tidbits today in an FT Opinion article from Jake Lynch of Macquarie:

• A recent survey of Chinese A-share investors found that 70 per cent believed they were investing in a bubble, matching the perception of most foreign observers.

  The A-share market has been cited, according to a standard calculation, as trading at a price/earning ratios of 70 times. Even worse, 30 per cent of earnings are alleged to come from investment income (that is, stock trading) - in effect, a giant Ponzi [pyramid] scheme.

  Combine the above with a reputation for questionable accounting practices, as well as the threat of $1,300bn of previously non-tradable shares becoming unlocked in the next two years, and it is no wonder that the A-share market is now off about 36 per cent from its highs.

  So is this correction just the first leg of the great unwinding? Not likely.

  In fact, it is hard to find evidence of a bubble at all. Take valuations: the benchmark CSI 300 index is now trading at 23 times 2008 consensus earnings forecasts. This is not cheap, but it is far from what we think of as bubble valuations and below its 10 year average of 30 times. How did we get from a multiple of 70 to 23 with a 25 per cent share price correction? First, bearish commentators were focusing on the smaller but more expensive Shenzhen market and looking backwards 12 months. Second, earnings grew 48 per cent in 2007 and the consensus forecast is for 32 per cent earnings growth this year.

  While 32 per cent seems like an aggressive number given the global slowdown, 7 percentage points come from a one-off tax break and a 25 per cent pre-tax growth rate may be achievable with a mid-teens nominal GDP growth rate - particularly when banks, oil and commodities are the main drivers.

  And what of all that investment income (which would presumably be turning into losses about now)? In fact, the 30 per cent figure was and is misleading as "investment income" contains all operating income from joint ventures and associates. Stripping those out, we found that only 9 per cent of non-financials income was generated by some form of asset revaluation.

  How much can we trust these numbers? More than 70 per cent of the CSI 300 market cap is now audited by the Big Four accounting firms using IFRS: the risk of accounting misadventures is now no higher than other emerging markets.

  The final issue supposedly dooming the A-share market is the unlocking of the non-tradable shares and the threat that the current holders of such shares will flood the market.

  Yet a quick glance at the A shares that have been unlocked since 2006 shows that only 10 per cent were actually sold into the market In fact, more than 75 per cent of the shares being unlocked belong to the government. That they would be sold down en masse is highly unlikely. A much more likely scenario is the one that the government itself gives - that it will control the issuance of supply to continue to foster a healthily developing market.

  Indeed, the increase of share supply is critical for a sustainable market. A shares have historically traded at high valuations because China's ratio of free-float market capitalisation to both GDP and savings remains far below other emerging and developed countries.

  In other words, there is not enough "supply" of shares relative to high "demand" from savers (especially given today's negative real interest rates). Both supply of and demand for shares are likely to rise rapidly in coming years, inevitably resulting in high volatility.

  Does any of this matter for international investors? With 72 per cent of the market cap of the MSCI China already dual-listed in Hong Kong and Shanghai (and the percentages rising monthly) the answer is yes. Hong Kong investors closely watch the price movements of the listed A shares and the recent correction in the A-share market has been an important cause of the MSCI China's underperformance relative to other emerging markets.

  While the A-share market may not yet be at a bottom, it can't be characterised as a bubble that is bursting.

Asset Allocation and Recessions

An article in the March issue of The Asset Allocation Advisor summarizes studies done of asset class performance (median total return) around recessions -- the ten recessions since 1947 for most asset classes, and for the five recessions since 1973, in the case of real estate and commodities. The key exhibit follows:










Since we don't know if or when the potentially current recession is beginning, and because every recession and set of market behaviors are different, trying to time one's asset rebalancing is risky to long-run performance. That said, the table presents a few reminders that stand out, at least to us:

(1) Stocks and Real Estate started to outperform only as it became clear that a recession had a good probability of ending (if one occurs at all). This is one reason why we've been very careful before raising our equity allocation.

(2) Commodities performed much better before recessions than within a year after -- Commodity run-ups were often contributors to recessions, and supply-demand tightness did not resume in the immediate aftermath of recessions, characterized by excess capacity. These are reasons why we haven't wanted to chase commodities, and why we're adding to underweight positions only cautiously, on pullbacks.

(3) Historically, Treasuries and Corporate Bonds performed better after recessions broke the back of inflationary worries characterized by most pre-recession periods. It's very hard to picture Treasury performance improving further after a 2008/2009 recession -- Unless inflation fears overtake the recent "flight to quality" prior to an upcoming recession. This could help make for a particularly nasty recession that would challenge many investors to maintain their asset allocation discipline. We view this as "entirely possible" and are happy to reduce overweight positions at our normal rebalancing intervals.

Despite our passive market timing (at least on the margin), we take to heart the article's final comments:

• Studies have well documented the risk of trying to time the stock market. Portfolio returns are more greatly reduced by missing just several of the upside movements in the market than they are enhanced by avoiding downside movements [highly dependent on how you measure]. For the investors who were lucky enough to reduce their domestic equity positions last October, the real test is whether they move back into the market at the right time to catch the upside. If they don't, their portfolios are likely to have lower returns than those who maintained their long-term equity allocations.
• In the last analysis, the best way to cope with the recession is to look forward and not backward, maintain asset allocations, and remind ourselves of the following lessons from history. Declines in the stock market are to be expected at the onset of a recession. Standard correlations among returns are likely to breakdown at the start of a recession with more classes producing negative returns than would normally be the case. Bonds will outperform stocks at the start of a recession, but within twelve months of the start of a recession, risky assets such as stocks and real estate will [normally] produce returns substantially in excess of bonds and reward investors for staying the course.

I added the world "normally" in the last sentence because an upcoming recession could be particularly long and nasty given the undoing of the enormous credit boom of the past five years, the "global imbalances" that threaten to unwind, the specter of peak oil production, and other factors. Thus, we think of ourselves as being a bit more willing to entertain a bit more market timing than we would otherwise.

"Quality" to Outperform--Seven Year View

GMO is one of the world's most successful asset managers, and one of the most famous asset allocation practitioners. They take a very long-term view and buy undervalued asset classes and sell overvalued classes even if they know they could be a year or more before the market turns their way. GMO's strategy and execution has been excellent by any reasonable standards.

GMO's "Recent Market Commentary" page is a treasure trove. A major standout is the extent to which GMO thinks "Quality" U.S. stocks will significantly outperform the U.S. equity market overall, and small-caps in particular. Pull up "GMO 7-Year Asset Class Forecasts (Jan 2008)" to see this in color. GMO believes "U.S. High Quality" will return 5.7%/year in the next seven years, versus only 1.9% for U.S. large cap equities and 1.3% for U.S. small cap equities. Thus GMO is calling for a dramatic reversal of the small-cap outperformance we've seen in the bull market we are now exiting.

GMO's call is driven partly by their 2007 call -- now proving correct -- that the credit bubble has propped up lower-quality assets to unsustainable levels. They believe it will take until 2010 to unwind enough of the excesses to create a U.S. stock market bottom. Jeremy Grantham's 4Q07 investment letter explains this point in detail.

Grantham explains how he would implement his Quality strategy:

• If you can do it, hedging out 100% of these positions with, say, a short on the Russell 2000 or equivalent would be much, much safer and probably more profitable [than owning the U.S. equity market at large].
  

He also mentions the upside/downside to this strategy: "The bigger the fundamental problems [with the economy] the more quality stocks are likely to outperform. The more the economy manages to muddle through the better emerging markets [and I would surmise lower-quality stocks] are likely to do."

We've Added AgileInvesting.com to Sources

We've started a trial membership with www.AgileInvesting.com because the proprietor J.D. Steinhilber argues that low-cost ETF vehicles and strategic asset allocation strategy are the best way for most investors to make money over time. He uses valuation tools to help him gauge when and how to rebalance his three recommended portfolios (Conservative, Moderate and Aggressive), and on the margin recommends some asset allocation recommendations that appear to be driven by long-term themes he perceives.

Here is blurb from his investor letter yesterday (a day before stocks' 4% rally today):

• At these prices, the S&P 500 will have fallen to valuation levels (based on normalized earnings that smooth business cycle fluctuations) that have marked the end of 70% of bear market declines since World War 2. Given the current state of credit and currency markets, it is certainly possible that stock should fall into the 30% of bear markets where stocks become extremely cheap, which we view as unlikely. The U.S. economy has overcome many financial crises in its history; although it looks as though the U.S. financial world is falling apart, with the passage of time, we suspect that the present time will approximate the point of maximum financial distress. One silver lining int he media last week is that in a Wall Street Journal survey, over 70% of economists now believe the economy has dropped into a recession. Bear markets driven by recessions don't end until recession is taken as an obvious fact. We appear to be rapidly approaching that point.

We'll look for more information on Steinhilber's valuation methodologies.

In the meantime, we're still waiting for our scheduled mid-year rebalancing date before adding to our underweight equities position versus our long-term strategic target. There's no denying, especially after today's confidence-building rally, that some investors will rush to buy out of fear of missing a market bottom. But for us to buy equities before our midyear rebalance, we'll wait to see oil pull back (it rose $3 today) and signs of real financial distress in some areas of the Developing Markets. As we've been writing, we think we're only "at the beginning of the middle" of a global financial crisis.