Why We're Still Underweight Equities (Just Less-So) - III

Equity markets' rally in the past month seems to reflect diminished fear of a financial system collapse (which we agree with, for now), but also shows little concern for the pending significant pressure we expect to see on corporate profits, fallout from the continuing credit crisis.

We articulated this view more fully in our post here.

A short FT article today summarizing the opinion of a Morgan Stanley strategist puts some additional figures on essentially the same view as ours:

• The bear market rally in European equities is over and corporate earnings over the coming year are likely to fall well short of expectations, says Teun Draaisma, strategist at Morgan Stanley.

  He points out that the MSCI Europe index has risen 11 per cent since hitting a trough on March 17, and believes there is limited further upside to the current rally.

  “We expected a bear market rally of at least 10 per cent on the back of a drastic policy reaction to the problems at hand,” he says.

  “Most policy action has been taken or is fully expected, while our all-important market timing indicators have given us the warning that the rally is over.”

  Mr Draaisma says inflation in Europe has been surprisingly strong, and that there have been tentative signs of the earnings downturn spreading beyond financials. He adds that money market stresses have not healed.

  “The biggest certainty for the next 12 months is that there will be a big earnings miss, as margins are at all-time high levels while top-line growth is slowing and costs are rising, and expectations are too high.

  “We forecast a 16 per cent fall in European earnings in 2008. Consensus earnings expectations have been cut 6 per cent so far this year but still imply 6 per cent growth, which is unrealistic.

  “The ‘financial end of the world’ has been avoided, but that still leaves us with a big earnings recession.”

To raise our equity allocations somewhat during the pullback of the past week, we've focused on the major trend toward investing for environmental sustainability, particularly companies we see as less vulnerable in the economic slowdown we expect to continue into 2009. (We've noted some of those companies under our Corporations subject link.) We'll continue to do so in the coming weeks, but with even greater selectivity after the equity markets' recent run run.

Why We're Still Underweight Equities (Just Less-So) - II

We've read a few too many times in the past two weeks that equity markets can, even should, rise sharply in the middle of recessions. And we keep reading that a second-half '08 economic recovery may be back on the table after all.

If this sentiment is becoming too common, recently-bid-up equity markets are becoming more vulnerable to the rash of further economic slowdown headlines that are coming in the next couple of quarters. (That is why most of our efforts to narrow our equity-underweight in recent weeks have been focused on major secular trends with less economic sensitivity.)

Pending bad news often seems well-understood and discounted .... until it arrives and stares investors in the face. And arrive it will. Every day that the credit market remains tight -- and tightens in many parts of the world -- means there's less new investment going into the economic pipeline, and less economic activity in the future. The massive credit unwind in the past six months is stealing significant economic growth from the future, and the credit unwind is still occurring in a pronounced way. (Again, that's why we're sticking with areas of the economy that are grabbing a rising share of investment, such as agriculture, water, and energy efficiency.)

It may be true that there's less chance of an financial collapse now than perceived just a few weeks ago, and that the reduced "tail risk" has helped lift markets in recent weeks. But if (we think when) world economies slow more substantially later in '08, investors will become more fearful of equities. We're waiting for that "second wave" of equity market fear to significantly raise our equity weighting.

A brief FT article tonight adds a few more specifics our concerns about another wave of economic slowdown news hitting market sentiment soon:

• Treasury sell-off hits housing recovery hopes

  The Fed sees the rise in yields as signalling increased market confidence in US economic prospects.

  However, mortgage rates also moved higher, making it more expensive to buy homes and less likely that existing homeowners will be able to refinance mortgages. [Recall, perceiving "the beginning of the end" of the housing crisis has been seen as a necessary condition to end the financial crisis.]
  

  Rates on 30-year fixed-rate mortgages rose to 5.87 per cent from 5.63 per cent a week ago, Bankrate.com said. Jumbo mortgages, those of more than $417,000, rose to 7.19 per cent from 7.06 per cent.

  “The back-up in yields is a concern as it will damage the economic outlook,” said Jane Caron, strategist at Dwight Asset Management.

  The three-month London interbank offered rate – Libor [to which trillions of dollars of loan costs are tied]– increased to 2.91 per cent from 2.71 per cent this week, indicating underlying stress in the financial system.

  Stocks rallied, said Anthony Conroy, head of equity trading at BNYConvergEx, because “the equity market is focused on a second-half recovery...and is not paying attention to the rise in bond yields yet.

Swensen on Volatility

NPR.org, a superb general news & culture website, has posted a very good summary of David Swensen's asset allocation philosophy. He's one of the world's leading asset managers, and has grown Yale's endowment by an incredible 16.8% in the past twenty years.

We've quoted his book "Unconventional Success: A Fundamental Approach to Personal Investment" several times in this blog. We also blogged Yale's latest investment statement, here.

Below is the NPR.org article, titled "Yale Money Whiz Shares Tips on Growing a Nest Egg." See the full link for the graphics.

• The turmoil in the stock market has a lot of people nervous about their retirement savings. If only they had David Swensen investing their money.

  Swensen manages Yale University's endowment. Last year, he made a 28 percent return, adding a whopping $5 billion to Yale's endowment, which is now valued at $22 billion. And that wasn't a fluke: Over the past two decades, under Swensen's watch, Yale's endowment has grown an average of 16.8 percent a year, more than any university, foundation or pension fund.

  In scary economic times like this, he cautions that individual investors shouldn't trust their instincts.

  "The human tendency in this kind of environment is to do something — to make a change," he says.

  Stocks seem risky, especially since they've been falling. Swensen says most people he talks to get nervous and want to sell stocks.

  "And that's exactly the wrong reaction," he says. "Buying high and selling low is not a way to make money. It's not hard, right? It's very simple: You want to do the opposite."

  Finding the Right Investment Mix

  To share the wealth with everyone, Swensen wrote a book about retirement investing that details his allocation strategies. He advises having the right long-term mix of stock index funds, bonds and real estate investment trusts (see chart below).

  But when stocks tank, that mix gets out of balance: For example, U.S. stocks that once constituted 30 percent of a portfolio may now constitute just 29 percent or 28 percent.

  When that happens, Swensen rebalances, shifting more holdings into stock index funds. Then, if the market comes back up and ends the day flat — where it started — Swensen sells those stock index funds.

  Swensen's ability to buy low and sell high on the market roller coaster has in some instances earned upwards of $1 million in a single day for Yale's endowment — just by rebalancing amidst volatility.

  "So you end up at the same place you started, except a million dollars ahead, that's not bad," he says. "But from rebalancing, not speculating — just sticking with your long-term targets."

  That's the upside: The stock market can end up flat, but investors still make money because they rebalanced when it was down. Sometimes the market keeps going down. But over time – five, 10 or 20 years — as the market keeps rising, Swensen says, investors can goose out extra returns by rebalancing along the way.

  Paying for Investment Advice?

  One of the reasons that Swensen can rebalance so frequently is that Yale, like other educational institutions, is tax-exempt. Before attempting to rebalance their portfolios, individual investors need to understand the tax implications of any trades they might make.

  Figuring out the right mix of what to own can be tricky. Many people seek out professional advice.

  And that's a good idea, says Jim Barnash, the national director of financial planning for Ameriprise Financial. He says in volatile markets like this one, people need quality one-on-one advice to make sure they're properly diversified.

  But Ameriprise's advice comes with a price: up to 1.25 percent of the total investment. That means an investor with a half-million dollars invested in a retirement 401K would end up paying about $6,250 a year in fees.

  Over 20 years, that person is losing hundreds of thousands of dollars because of fees. Of course, that's better than not investing at all, and a lot of people want an adviser to help them.

  But Swensen says most of these investment services provide pretty mediocre advice, and it's just not worth giving them a percentage of your life savings.

  "That's the wrong path," Swensen says. "And the reason it's the wrong path is it's a very, very expensive path."

  Index Funds or Mutual Funds?

  Swensen says fees are also the big reason you should buy index funds instead of classic mutual funds. Index funds, which track market segments like the S&P 500, are a lot cheaper.

  Swensen says the vast majority of professional mutual fund managers fail to beat those indexes.

  "When you look at the results on an after-fee, after-tax basis over reasonably long periods of time, there's almost no chance that you end up beating an index fund," he says. The odds, he says, are 100 to 1.

  Swensen, who cautions against trying to pick individual stocks, favors nonprofit funds like Vanguard and TIAA-CREF. There too, the lower fees will mean more money in your pocket over time.

The article finishes with a more detailed listing of the index funds that Swensen recommends investors use to establish their asset allocation.

"Do Traders Win?"

The March issue of Index Investor highlights a 2/17/08 Vanguard report titled, "Do Traders Win? Trading Behavior and 401(k) Portfolio Performance" that offers, at first glance, some hope for various 401(k) investment styles, but disappointment for active traders:

• Traders versus nontraders. 401(k) traders realized higher returns than nontraders but also assumed higher levels of risk. After adjusting for risk, the difference in returns between the two groups disappeared.
  
• Rebalancing. Passive rebalancers, who hold only balanced or life-cycle funds so are automatically rebalanced by their fund, realized excess annual returns of 84 basis points compared with nontraders on a risk-adjusted basis. Active rebalancers, who on their own move their 401(k) portfolio's equity allocation back to a given target, earned 26 basis points in excess risk-adjusted returns. However, we estimate that only 9% of participants rebalanced their 401(k) account on an active or passive basis.
• High turnover. While some level of trading is a risk-enhancing strategy, high portfolio turnover is not. Traders with the highest turnover rates lost 72 basis points per year compared with traders with the lowest turnover ratios.
• Implications. Our findings underscore the value of rebalancing as an essential strategy for 401(k) participants.

I write that the report offers hope at first glance for various 401(k) investment styles, note that Vanguard drew its data from only the 2003-2004 period for stocks, a bullish period for stocks that doesn't capture individual investors' tendency to sell close to cyclical troughs and buy near cyclical peaks. The vast majority of the broadly-conducted research we've seen favors disciplined rebalancing over active management even more compellingly than the Vanguard report does in its indication of an 84 bp/yr advantage for passive rebalancers.

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.

Still "The Beginning of the Middle" (of the Bear Trend)

We've written several times about the stages of a bear and bull market.

Here is another simple way to look at it, highlighted in the WSJ's Deal Journal. From Howard Marks's memo to his Oaktree investors:

• I've formulated...the three stages of a bear market: (1) when just a few prudent investors recognize that, despite the prevailing bullishness, things won't be that rosy, (2) when most investors recognize things are deteriorating, and (3) when everyone's convinced things can only get worse. Certainly we're well into the second of these three stages.

But the key is to add to equity allocations well into the third of these stages.

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.

"I Knew The Bubble Was Bursting" and Asset Allocation

The best market timer on earth is Hindsight. Perhaps most investors saw the current credit crisis coming, but only some of them positioned their portfolios correctly. Those who "just knew it" will try again another day, by getting long with leverage when they see a bottom, or by taking profits and going short after a rally. The question is, how many of them will succeed? Asset allocation is based partly on the premise that very few investors succeed in enhancing long-run gains by trying to time the market over the course of their lives.

So we were delighted that the February issue of IndexInvestor.com summarized some of the latest research on whether market timing is a good strategy for individual investors. Their conclusion: not for the vast majority who have no proven track record. Inhibitors to long-run outperformance include (1) Psychology, such as bias toward paying attention to evidence that confirms rather than refutes one's view (IndexInvestor.com highlights "Do Investors Overweight Personal Experience?" by Kaustia and Knupfer), (2) Volatility (IndexInvestor.com highlights "Black Swans and Market Timing" by Javier Estrada, which shows extreme events to occur more often than theoretical "normal distribution" predicts, (3) Bubbles & Crashes: John Maynard Keynes' maxim that "The market can stay irrational longer than you can stay solvent, (4) Reversals, evidenced by a 2006 paper that showing that severe down-days are negatively correlated by subsequent sharp reversals that make market timing exceptionally tricky over time.

IndexInvestor.com highlights papers on both sides of the debate, such as "Riding Bubble", by Guenster, Kole and Jacobsen that suggests it may be worthwhile to try to ride bubbles, and "On Turning to Market Timing" by Cotton arguing that timing is not a good strategy for most investors. The article particularly touts James Montier's Behavioral Investing: A Practitioner's Guide to Applying Behavioral Finance.

These and other papers remind us of one overall point: professionals dedicate a vast amount of time and energy to timing the market correctly, but only some of them can succeed. Individual investors trying to play the Market Timing game should make as few major timing decisions as possible, and only after they've established a track record of being correct, and only when the evidence they've gathered lines up contrary to "consensus thinking" among institutional investors. It's a tall order. Stick to disciplined asset allocation, but ambitious investors
should continue to study hard in search for rare opportunities.

Asset Allocation: Tough to stay disciplined when markets swoon

With equity indices swooning, many individual investors' "fight or flight" instincts take hold. It's tempting to sell plummeting equity holdings, or jump into skyrocketing Treasuries or commodities. But that shouldn't be the first reaction. Rather, for most investors, now is a time to consider long-term asset allocation objectives rather than speculate on next week's trading activity. Looking to long-term wealth creation, now is the time for an individual investor to: (A) Re-calculate one's exposure to each of four major investment classes: equities, inflation hedges, deflation hedges and cash. (Include real estate equity as a sub-component of the long-term inflation hedge allocation.) (B) Discuss with a Fiduciary Advisor whether one's current asset allocation is consistent with long-term objectives. (C) Consider when one's next re-balancing -- or shifting between asset classes -- will be, in order to bring current allocations more in line with long-term objectives.

Consider words from David Swensen, the chief investment officer of Yale University, in his book Unconventional Success: A Fundamental Approach to Personal Investment (below). Swensen's long-term performance and his references to research findings have made him a highly regarded source for personal investors.

• Evidence points overwhelmingly to the conclusion that active [portfolio] management of assets fails to produce satisfactory results for individual investors. Two factors explain the individual's predicament. The first problem stems from the investment choices available to individuals. High costs and poor execution doom the vast majority of offerings. The second problem concerns responses by individuals to markets. Research shortcomings, rearview-mirror investing, and investor fickleness (in the face of both adversity and opportunity) cripple most investment programs. If the outside investment manager fails to diminish investor assets, then the investor steps in to administer self-inflicted pain." (Page 6, 2005 Edition)