Now, "The End of the Middle" of the Financial Crisis

We've gradually crept back into equities in the past month as we've blogged that the financial crisis has moved from "the beginning" to "the beginning of the middle." We now think a new milestone has been reached: we've progressed to "the end of the middle." (We're just one-step closer to the ultimate buy-signal, "the beginning of the end.")

So, what's changed? There are now many more reasons for the Fed to diminish the pace of its rate cutting, the most important of which is that the financial crisis appears to be easing by many indicators. Furthermore, the main global disaster scenario is premised on a U.S. dollar that weakens to oblivion -- If the Fed is able to diminish its rate-cutting pace, the dollar will find a fresh source of support to reduce the chances of a dollar melt-down. All of this could well combine to moderate commodity prices for a while, and that would be a crucial element in a more stable macro-economic outlook -- a necessary condition for restoring more of a balance that most securities markets will find bullish.

In other words, we continue to "muddle through" the financial crisis, which is the bullish scenario for equities. We still face a potentially uncomfortable global economic slowdown that will raise additional risks, such as that of a Developing Market crisis in some areas. That, in our view, would signal the real "beginning of the end" of the crisis, and a very good buying opportunity in equities.

The following Bloomberg article summarizes why we believe the financial crisis has taken a step toward ultimate resolution:

• Commodities Tumble Most in Five Weeks After Dollar Rebounds, by Ron Day

  April 29 (Bloomberg) -- Commodities fell the most in five weeks as a rally by the dollar eroded demand for energy, metals, crops and livestock as alternative investments.

  The weighted UBS Bloomberg Constant Maturity Commodity Index fell 1.9 percent to 1,508.21 at 4:11 p.m. New York time, the biggest drop since March 19. Wheat prices tumbled to a five- month low, crude oil slid more than $3 a barrel and silver dropped almost 3 percent.

  The dollar was poised for the first monthly advance against the euro this year on speculation the Federal Reserve will signal that it has finished lowering U.S. interest rates after six reductions since September. A week ago, the dollar plunged to a record against the euro, boosting demand for raw materials as a hedge against inflation.

  ``This may be a major change in perception about the dollar,'' said Dale Durchholz, a market analyst for AgriVisor Services Inc. in Bloomington, Illinois. ``The run-up in commodities prices has been tied to a weakening, and now it appears it may be reaching a bottom.''

  The UBS Bloomberg index has dropped 4.2 percent from a record 1,573.84 on Feb. 29. Before today, the gauge climbed 20 percent this year, while the Standard & Poor's 500 Index declined 4.9 percent and the dollar slid 5.5 percent against a weighted basket of the euro, yen, pound and three other major currencies.

  Futures on the Chicago Board of Trade show an 82 percent chance the Fed will cut the target rate for overnight lending by a quarter-percentage point to 2 percent tomorrow and odds of 71 percent that the rate will be held at that level in June.

  `Take Money Out'

  Fed Chairman Ben S. Bernanke is persuading investors that the financial markets are working again, some analysts said.

  The S&P 500 Index has rallied since the central bank backed the purchase of Bear Stearns Cos. on March 16. Companies sold $45.3 billion of debt last week, the most ever. High-yield bonds are poised for their best month in five years, and mortgage securities are outperforming Treasuries for the first time in 2008.

  ``Commodities have been the darlings of the investment space recently,'' said Eric Wittenauer, an energy and metals analyst at Wachovia Securities in St. Louis. ``Some investors may be looking at these developments as a sign to take money out of commodity markets.''

  Oil, gold, copper and tin have climbed to records this year as demand outpaced supplies. Rice, corn, soybean and wheat prices have also jumped to records, partly because of adverse weather and soaring consumption in Asia. Suring food costs have sparked protests and riots in countries including Haiti, Indonesia, Mexico and Egypt.

  `Fundamental Imbalance'

  ``The rising dollar won't change the fundamental imbalances driving commodity prices, but it may slow the climb as commodities traded in dollars become more expensive internationally,'' Matt Sena, co-manager of New York-based Castlestone Management LLC's Aliquot Commodity Fund, which oversees $900 billion in assets, said in an e-mail.

  Crude-oil futures for June delivery dropped $3.14, or 2.6 percent, to $115.61 a barrel the New York Mercantile Exchange. Yesterday, the price surged to a record $119.93. Natural gas tumbled 3.9 percent, and gasoline declined 3 percent.

  Wheat futures for July delivery fell 32.5 cents, or 3.9 percent, to $8.085 a bushel on the Chicago Board of Trade. Earlier, the price touched $8.0175, the lowest for a most-active contract since Nov. 21. Corn and soybeans also dropped.

  Silver futures for July delivery declined 48.3 cents, or 2.8 percent, to $16.64 an ounce on the Comex division of the Nymex. Gold, which often moves in the opposite direction of the dollar, fell 2 percent to $876.80.

Finally, "Real" Asset Allocation For Individuals

The famously successful asset allocation strategies of top investors and university endowments such as Yale have been the envy and goal of many sophisticated individual investors for years. Yale's endowment, for example, is up an astonishing 16.1% per year for the past 22 years, with remarkably low volatility, since current head David Swensen took over. Look at the Yale annual report and our blog summary "Yale and You" here to see how Yale does it.

But individual investors haven't been able to participate directly in such diverse and exclusive funds, and instead have had to (1) try to construct their own sophisticated asset allocation from the bottom-up, (2) hire professionals for enormous fees and scant accountability, or (3) settle for the badly inferior "life-cycle" funds that offer a simplistic mix of stocks vs bonds as individuals age.

Happily, today Vanguard announced its Managed Payout Funds, which will help individuals gain access to more of the true diversification benefits that professional asset allocators achieve. Vanguard will offer three funds containing not only U.S. stocks & bonds (which are often highly correlated and therefore far from optimal), but also international stocks, REITs, Treasury Inflation Protection Securities (TIPS), commodity-linked investments, and market-neutral equity funds. These additional asset classes have different return and correlation characteristics in comparison to U.S. stocks & bonds; institutional investors have been exploiting them for years to obtain higher returns and lower variability of returns year-to-year.

Vanguard will construct its Managed Payout portfolios to achieve closer-to-optimal portfolios (in a Markowitz sense) than most investors can achieve for themselves. The new funds will pay out a percentage each year to investors needing retirement income and (probably) better risk-adjusted returns than are widely available to them otherwise. Vanguard will re-balance each asset class regularly to accord with long-run allocation targets, something individual investors also fail to do. Astonishingly (though perhaps not for Vanguard), annual fees will be only 0.57-0.58%.

Of course, the new funds' reward/risk tradeoffs won't come close to the characteristics of the best institutional asset allocators, who beat market-averages within traditional asset classes, and push into private investments and emerging asset classes that Vanguard's public funds will not be able to incorporate. But Vanguard's Managed Payout product will open a new efficiency frontier to many individual investors.

Another Glimmer of Hope: The Repo Market

Many indications of acute credit crisis remain, and the economic drag from a constricted credit market will remain for quite some time, but some credit markets are also giving some modest signs of crisis-alleviation. As we see a few signs like this, we're encouraged to (1) add slightly -- not significantly -- to our equity allocations (which remain underweight overall), (2) avoid being very overweight Treasuries after their tremendous rally, (3) be less likely to trim our municipal bond weighting, (4) comb for other attractive assets with low correlation with our portfolio.

From Bloomberg:

• The dollar isn't the only casualty of the Federal Reserve's rescue of seized-up credit markets. Bond traders are finding there is nothing special about Treasuries anymore, now that the Fed accepts substitutes for government securities as collateral -- having concluded it wasn't enough to reduce the benchmark interest rate for overnight bank loans six times since September.

  As recently as March 21, Treasuries were in such demand that traders were willing to lend cash at rates 2 percentage points less than the Fed's target for overnight loans if they could obtain the securities as collateral. Now, the gap is back in line with the 0.06 percentage point average in the 10 years prior to August, when subprime mortgage losses spread.

  The $6.3 trillion-a-day repurchase agreement, or repo, market is a barometer of sentiment because it's where firms finance trades. A narrowing of the spread between the so-called general-collateral and federal-funds rates may suggest declining demand for U.S. government debt. Treasuries have lost 0.8 percent on average since March 20, when the central bank expanded the type of debt it would take in return for the securities to include mortgage and commercial real estate bonds.

  ``It is an indication that the markets continue to lurch uneasily back toward normalcy,'' said Ward McCarthy, a principal at Stone & McCarthy Research Associates in Skillman, New Jersey, and a former chief financial economist at Merrill Lynch & Co. and senior economist at the Fed. ``The pressure in repo trading has finally begun to ease.''

But we're still a headline or two away from further cracks in markets. Our asset allocation moves still reflect our view of this risk.

Municipal Bonds: Still Undervalued, Probably

We've held a modest weighting in municipal bonds since early March when yields struck far below Treasury yields, despite munis' tax-free status. Investors' flight to Treasuries amid growing credit crisis resulted in level of muni devaluation that only occurs a few times in a lifetime.

Our position in munis was modest, because we worried about the tail risk of financial collapse, as we wrote about in our post (Munis Ain't No Treasuries). Municipalities have certainly been known to default, especially when they're playing with complex financial instruments, suffering from sagging property tax revenue, etc. So munis are not a replacement for the "deflation hedge" portion of one's asset allocation. But they can certainly play a role when they're historically cheap.

But munis are still yielding more than Treasuries, as highlighted in a SeekingAlpha update today.

Our reasons for holding munis (we favor Vanguard's long-term tax-exempt funds) remain the same as when we wrote on March 17 (and the position has been working so far): (1) After a big selloff, munis were yielding more than similar-maturity treasuries despite munis' tax-free status, and smart money was buying; (2) Investors anticipating U.S. tax increases in the next administration saw the advantage of owning muni bonds only rising, and (3) Warren Buffett was reportedly seeing brisk business for the new muni bond insurer he established, and (4) Muni bonds have rallied, showing a healthy reaction to positive developments.

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.

Yale and You

It's generally well-known -- and famous among asset allocators -- that Yale University's endowment has crushed the benchmarks in the past 22 years since David Swensen has been running it. Swensen is up 16.1% versus the S&P 500's 12.3% during the period, and he his volatility has been much lower.

First I'll transmit a few nuggets on how they do it (see the report), then I'll quote a terrific article by Geoff Considine on how individual investors might try to imitate.

• Read about how Swensen's team does it, here in the Yale Endowment 2007 report. Its 6/30/07 asset allocations were: 23.3% Absolute Return (vs 19.5% Educational Institution Mean), Domestic Equity 11.0% (vs 26.3% EIM), 4% Fixed Income (vs 12.7% EIM), 14.1% Foreign Equity (vs 22.1% EIM), 18.7% Private Equity (vs 7.0% EIM), 27.1% Real Assets (vs 10.1% EIM), and 1.9% cash (vs 2.3% EIM). A few nuggets from the report: In all its investing, Yale goes to great lengths to seek investments managers whose interests are aligned with their investors. Alpha comes largely from security selection. Intelligent diversification is crucial. Absolute Return: actively managed funds, half event-driven, half value-driven, involving hedges that make these funds essentially no correlation to domestic stock and bond markets. Domestic Equity: underweight because it's a highly efficient market, and hard to find what they're looking for: investment managers "with exceptional bottom-up fundamental research capabilities....with high integrity, sound investment philosophies, strong track records, superior organizations, and sustainable competitive advantages. Fixed Income: underweight because "they have the lowest historical and expected returns of the six asset classes that make up the Endowment." Foreign Equity: similar comment to Domestic Equity. Private Equity: overweight "stemming from the University's strong stable of value-added managers that exploit market inefficiencies (not ones that simply add financial leverage to their acquisitions). Real Assets: (Real estate, oil and gas, timberland) sensitivity to inflationary forces, high and visible cash flow, and opportunity to exploit market inefficiencies owing partly to Yale's long-term partnerships with managers.

Next, from Considine's article, on helping retail investors translate Yale's approach to their own portfolios. [Considine runs Quantext (portfolio management software, highlighted below), and his SeekingAlpha articles can be found here.]

• Swensen discusses what he thinks individual investors should be doing. notably, he does not suggest that retail investors take on non-equity assets like timber that have made Yale's performance so strong. Instead, he proposes a plain vanilla portfolio that did not look all that great to my eye (below)
• 

• ....When I ran this portfolio through our forward-looking portfolio management software, Quantext Portfolio Planner (QPP), the results were essentially what I expected. QPP projects that this portfolio will match the expected return of the S&P 500 on a going forward basis (8.2% per year) , with less risk (the projected standard deviation is 11.8% vs. 15% for the S&P 500). This is okay, but far from spectacular -- and, notably, far below the 1-to-1 ratio between expected return and standard deviation that Mr. Swensen is planning for with the Yale endowment.
• Mr. Swensen is famous for seeking out asset classes with low correlation to broad equity indices, such as a range of commodities, timberland and other real assets. Where are these in the retail portfolio? Mr. Swensen only has 12% of Yale's portfolio in domestic equities but he is proposing that retail investors put 30% of their assets in domestic equities. Whilte it is true that Mr. Swensen has access to private equity and other assets that the average retail investor cannot easily include in his/her portfolio, it is certainly possible to get a lot closer to the Yale model.
• To broadly replicate the kind of performance that Mr. Swensen has engineered for Yale in the retail portfolio, I replaced all the Vanguard funds with ETFs and then added commodities (via DJP), a timber REIT (PCL), a very large electrical utility (EXC) and a large oil company (COP). The idea here is to provide a significant exposure to commodities and real assets. I have also ditched the short-term bond fund. our New model portfolio looks like this:
  
• 

Here I'd note that substituting individual securities for asset classes significantly diminishes diversification, but I'll continue to quote Considine below because ETFs can be easily substituted for the individual companies he has chosen. Considine adds:

• Quantext Portfolio Planner projects that this portfolio has an expected return of 10.1% per year, with a standard deviation of 11.6% per year -- almost exactly what Mr. Swensen says that he has targeted for the Yale portfolio.

He concludes:

• Forward-looking models (like Quantext Portfolio Planner) are the standard of practice in institutional money management, and the technology is gradually making its presence known among retail investors and their advisors (as shown by the Stein-DeMuth book [called Yes, You Can Supercharge Your Portfolio]. What would your portfolio look like in one of these forward-looking models?
  

Munis: They Ain't No Treasuries

Value buyers of Municipal Bonds a few weeks ago seemed to have a lot in their favor. Principal headlines were: (1) After a big selloff, munis were yielding more than similar-maturity treasuries despite munis' tax-free status, and smart money was buying; (2) Investors anticipating U.S. tax increases in the next administration saw the advantage of owning muni bonds only rising, and (3) Warren Buffett was reportedly seeing brisk business for the new muni bond insurer he established, and (4) Muni bonds staged a sharp rally, showing a healthy reaction to positive chatter.

But Asset Allocation Adherents Knew Better

Municipal bonds aren't seen as a reliable way to fulfill one's deflation-hedge allocation. That's left to U.S. Treasuries, aptly highlighted by David Swensen, chief investment officer of Yale University, as he writes in Unconventional Success: A Fundamental Approach to Personal Investment:

• The purity of noncallable, long-term, default-free Treasury bonds provides the most powerful diversificaton to investor portfolios.

The last few weeks support the point. Long-term munis, which by some measures have underperformed long-term Treasuries by upwards of 25% in the past year, have even slightly underperformed Treasuries since the muni nadir on February 29, 2008. Many investors are still selling munis to raise capital to meet the obligations to their panicked lenders, and some municipalities have cranked up new issuance (new supply to the markets, pressuring prices lower) as their other borrowing vehicles have become far too expensive amid the credit crunch.

Now we turn back to Swensen, who comments on munis:

• Investors who substitute tax-exempt [muni] debt for core holdings of Treasury bonds dilute the value of fixed income's diversifying power by introducing call risk and credit risk to the bond portfolio.