We had occasion to attend a luncheon and meet former Federal Reserve Chairman Ben Bernanke who was the featured speaker. The luncheon was held in Boston on a recent Friday, shortly after the September announcement that the Fed would keep rates unchanged. There were about 80 financial professionals in attendance from both the wealth management and institutional money management communities, and the format was a “fireside chat”; a moderated conversation with Dr. Bernanke, after which followed a question and answer session.
“In order to properly understand the big picture, everyone should fear becoming mentally clouded and obsessed with one small section of truth”
-Xun Zi, ancient Chinese philosopher
“[i]n planning for battle I have often found that plans are useless, but planning is indispensable”. –Dwight Eisenhower
We had a conversation with a client in recent weeks which spurred our own reflection of how investors tend to view markets, expectations, and the very act of investing. By investors, we are referring to a wide swath of financial market participants, which include individual investors, members of the financial media, and even financial advisors. The conversation centered on a discussion this client recently had with some of his associates regarding an article printed in the Wall Street Journal on December 30th.
Billed as a retrospective of sorts, it was titled, “Lessons From a Year of Market Surprises”, by Jason Zweig.
Many financial publications poll various “experts” around this time of year seeking out opinions and view-points as to what may be expected in the coming 12 months. This is a long-lived tradition. We recalled the headline and quickly scanning the article—but we went back and dug it out for further review. The crux of the article pertained to macro-economic “predictions” that were made last January by 49 “business economists” (the definition of which remains murky however). Forty-eight of the forty-nine economists surveyed expected the yield on the 10-year Treasury note, about 2.9% around the time of the survey, to exceed 3% by year-end, with an average forecast of 3.52%…expected oil to end 2014 at about $95 a barrel, up from about $92 at the time of the survey. In essence, according to the article everybody was wrong about everything—and very much so. Although we find it hard to believe the WSJ issued only a two-question survey pertaining to interest rates and oil prices. Nothing is revealed in the article about “predictions” relating to market index levels, GDP or other econometrics which economists generally concern themselves with (perhaps they were closer to the mark, and less newsworthy). The article went on to speak about “the forecasting follies” rolling on this year, and made this statement: Unlike, say, meteorologists, who predict specific outcomes at exact times and use percentages to indicate how confident they are about their forecasts, financial pundits rarely assign probabilities to their predictions and make judgment calls that can be hard to categorize” (emphasis added). Well, at least we know now that the “business economists” being surveyed are actually “pundits”—whatever the definition. We drew a sharp distinction between the two in our September Outlook.
Lastly, this exquisitely vague piece of advice for WSJ readers: As the year turns, investors should remember that they should tune out most, if not all, forecasts and stick with a game plan that will do reasonably well no matter what happens. Here, we were tempted to make a snarky comment about the “Unicorn portfolio” that does well in all conditions. It doesn’t exist. However, assuming the author recommends tuning out all future economic polling his publication conducts, we realize that deconstructing this statement highlights an issue most financial advisors are confronting these days–the individual definitions of what constitutes “reasonably well” (putting aside definitions of “no matter what” for the moment). The fact is, there is no universal definition—other than the long-run rate of return assumed by your financial plan.
In 2014, most major non-US markets were down for the year. Emerging markets were down as a whole, cash returned nothing, small cap equities were in the low single digits, and bonds were single digits. To attain the return of the S&P 500, you essentially had to own the S&P 500. To beat the S&P 500, you needed to split your money between the S&P and REITs. Not exactly a diversified portfolio. Yet, we have encountered instances recently in which “reasonably well” to some would have been the return of this single market index. We’re disaggregating this article because we recognize several of the explicit and implicit themes in our daily conversations with clients. Inasmuch as this article (and others like it) gives a voice to frustrations investors experience with surprise developments, which include developments that run counter to “predictions”–the price of oil, the level of interest rates–we feel it is important to understand what the actual methodology of forecasting entails. Dwight Eisenhower is attributed the quote, “[i]n planning for battle I have often found that plans are useless, but planning is indispensable”. Generals, football coaches, securities analysts, portfolio managers, economists and strategists all must begin with a set of assumptions.
In sharp contradiction to the WSJ article assertion quoted above, in the financial universe, these assumptions and predictions are, in fact, assigned probabilities. In fact, entire quantitative research departments are employed to test these assumptions using regression analysis, and to assign and fine-tune confidence intervals and map probability distributions of forecasts involving securities, sectors, asset classes and all manner of economic metrics. Investing itself is a probabilistic activity. As such, forecasts made by financial market participants are themselves conditional probabilities. The rational decision maker is assumed to update their beliefs on a regular basis as new information becomes available. There is actually a very formal process for doing so which includes the use of something called “Bayes Formula”. So we again take issue with the conflation made between “punditry” (annual predictions, judged once a year), and the serious business of financial forecasting (which by definition involves forecast updating). A more serious and informative polling piece would have allowed for, and tracked updated assumptions throughout the year. As we again draw the line between “punditry” and money management, we feel it is important also to draw a distinction between “predictions” and “expectations”. The former is a one-time forecast—little better than a guess. It will either be right or wrong in the end. Expectations, however, are essential to planning, and are updated regularly given the constant flow of new data. Lastly, our reference to a “Unicorn Portfolio” that “does reasonably well…no matter what happens” is actually the basic premise behind portfolio diversification.
As wealth managers, CCR will always recommend a well-diversified portfolio. It is our explicit acknowledgement that no forecasts are bullet-proof, and over one year-or less, they are even less so. In this country, the S&P 500 has stayed in the headlines throughout the year. It was often described as “overvalued” early in the year (recall CNN Money’s “Fear and Greed Index” we wrote about in September), while of late it ha throughout the year. It was (annual predictions judged once a year)f A)ned Mid Cap Value (JVMIX).s been highlighted as the best major market index for the second year in a row. The following “periodic table”, supplied by JP Morgan, lists major market segment returns going back 10 years. Let us make a few observations: First, the S&P 500 was up 1.1% at the end of the third quarter last year—much further in-line with many market forecasts of a more subdued year (relative to 2013), though as you can see, it ended the year up 13.7%. Second, the “Asset Allocation” block (white), which represents a general 60/40 allocation among all the listed asset classes, returned mid-single digits in 2014.
Last, a view of the variability and disbursement of returns over the last 10 years depicted by the periodic table should make clear that a well-diversified portfolio is the best solution for controlling the volatility of returns upon which a financial plan projection depends. Before moving on to what may be in store for us, we’ll say our comments to our client regarding the article included an acknowledgement that while the “predictions” about oil and interest rates were incorrect in 2014, this does not mean that they’ll be incorrect for 2015—or 2016. Our September Outlook included a description of the “Gambler’s Fallacy”, a human behavioral bias that frequently pops up in finance. This behavioral bias recognizes the reality of mean reversion (all markets and valuation measures tend to be mean-reverting mechanisms), but then assigns specific time-frames for particular reversions to occur within—a much more speculative endeavor. There are two simple ways to avoid the Gambler’s Fallacy, as it pertains to your investment returns: 1) recognize the variability or return dispersions over shorter periods (study the periodic table), and 2) remain focused on longer time horizons to evaluate performance. US Equities As we have related along the way, various conversations with clients over the last twelve months have included their expressed concerns over the many “new highs” reached by the Dow Jones average and/or the S&P 500. Interestingly, some clients have expressed surprise their diversified portfolio returns were not closer to the S&P mark by year end. In May of 2014 we printed the historical US equity market P/E comparisons (reprinted, left). In this letter we have also printed the updated valuation comparisons through December 31st (on the right). It is apparent from these charts that areas of the US markets that were below their 29 year average P/E just months ago have, by and large, attained “fully valued” status. Further, other areas of the US markets are overvalued based on this standard (we acknowledge the difference in sampling period—though the denominators are little changed). To us, “fully valued” is still not “over-valued” and should not by itself be cause for alarm. Stocks generally advance due to either P/E expansion or actual earnings growth. The former could be said to be a measure of expectation, while the latter is the proof that expectations were founded (and implicitly validating current future expectations).
Our expectations for US equities in the coming 18 months or so are for little to modest P/E expansions. However, we expect there will be some fairly solid earnings and profit margin increases, though with more sector differentiation. As earnings are the denominator the P/E ratio—there is plenty of room for stock-price expansion. The US economy can finally be said to have found its stride, with unemployment having declined significantly in recent quarters, and, importantly, a major “tax cut” having been supplied by tumbling oil prices. We have grown used to speaking of the US market as a monolithic creature over the last five years, and that, we expect, will change (perhaps dramatically) in the years ahead. As evidenced from the charts, US equity segments are very tightly clustered on a P/E basis. This is not the historical “norm”, particularly this late into a market cycle. A resoundingly common theme we have polled over the last year (and more) within the financial research we consume is the expectation of significant divergence among markets, sectors, and even individual stocks. Divergence drives differentiation. Obviously we have already seen market divergence in international markets over the last 18 months. This trend will likely continue as Europe and Japanese monetary policy begins to sharply diverge from US and UK policy. Divergence, though, is likely to extend to sectors and individual stocks within US market sectors, given varying levels of structural leverage among US companies. To an extent, we are witnessing this within the “oil patch” currently. There, the US energy sector, long the darling of the US stock market, has diverged significantly from the rest of the US equities markets. Within the energy sector itself, differences in balance sheet leverage have forced further distinctions. Oil prices remaining at current levels for a prolonged period may ultimately result in true distress for smaller, highly leveraged firms. Also, with the US Dollar sharply higher versus our major trading partners—particularly Europe and Japan, US exports have become increasingly expensive to purchase abroad. This reality could act as a counter-force to cheap energy prices and possibly slow non-US sales for companies reliant on global growth—another source of divergence. In such an environment, broad index returns going forward may finally submit to more nimble, actively managed funds. These actively managed funds have spent the last couple years identifying and accumulating relative “value” in stocks and sectors which may be less laden with these headwinds, and their returns could be positively distinguished from broad indexes going forward. In short—and not surprisingly—US Equity managers’ forecasts suggest investors reign in expectations for the coming year.
While the same forecasts a year ago were seemingly undone by the stock market’s fourth quarter run, we concur that rising valuations, rising interest rates, anemic global growth, and an exceptionally strong US dollar present headwinds against an organically improving economy and kinetic assistance of low oil prices. We hope investors view these expectations as encompassing a foreseeable future, and not as forecasts of a twelve month period certain. Source: Compustat, I/B/E/S, Goldman Sachs Global Investment Research, and GSAM, as of 31-Aug-2014. NTM P/E refers to next twelve months price/earnings ratio, also known as the forward P/E ratio. Normalized standard deviation is an attempt to remove the statistical bias of higher P/E ratios having inherently higher standard deviations. Standard deviation refers to how much variation there is around the mean value. Z-score refers to how many standard deviations the values in the chart are from the mean value. Past performance does not guarantee future results, which may vary. Source: Compustat, I/B/E/S, Goldman Sachs Global Investment Research, and GSAM, as of 31-Aug-2014. NTM P/E refers to next twelve months price/earnings ratio, also known as the forward P/E ratio. Normalized standard deviation is an attempt to remove the statistical bias of higher P/E ratios having inherently higher standard deviations. Standard deviation refers to how much variation there is around the mean value. Z-score refers to how many standard deviations the values in the chart are from the mean value. Past performance does not guarantee future results, which may vary. Non-US Equities We intentionally delayed our effort of compiling this piece before hearing the announcement in January from the ECB concerning their much anticipated economic stimulus plan. Consensus expectations had been quite high for several months that a massive monetary stimulus would be needed (and delivered) to reverse the spiral towards deflation the Euro has experienced over the past year. Unfortunately, the Europeans have had a tendency to disappoint, owing to the comparatively awkward political structure of their central bank (compared to the Federal Reserve, or the Japanese and UK central banks). A disappointment at this crucial juncture would likely have taken the markets and this Outlook in a different direction. The announcement of a massive quantitative easing effort (at least $1.1 trillion over 18 months), as we mentioned, was widely anticipated. This constitutes a major effort by the ECB to reconstitute some inflationary forces back into their economy and to avoid disastrous deflation. In response to this news, equity markets in the US were subdued, but European stocks (measured in Euro’s) rallied. The Euro tumbled down 7% this month, and the US Dollar continued to soar as investors sought out comparatively higher rates in the US. A year ago we identified European stocks as an opportunity for investors given their comparatively cheaper valuations and the nascent economic recovery. Forecasts for Eurozone growth last year were generally in the 1.00%-1.50% area. We mused in our January Outlook that given the prospect of lower valuations, economic recovery, and stimulus that EU stocks might even outperform the US (thereby falling into the gambler’s fallacy trap ourselves). Unfortunately, this recovery faltered in 2014, and growth came in at 0.80%, in part because of the economic slow-down that tends to accompany falling inflation. We continue to view European equities as comparatively attractive relative to their US counterparts. Our periodic review commentary has pointed out that US and EU large and mega-cap companies are all drawing revenue from around the globe and are subject to the same global economic forces. All things being equal, we would rather buy a stock trading at 13x or 14x earnings than at 16x or 17x. The sharply falling Euro should also add a competitive advantage for Europe’s export business, at least in the short run. We’re not alone. Investors have a global tool-kit available to them today and according to the Investment Company Institute for the year 2014 (through November), $89 Billion has flowed into World Equity Mutual Funds (which include Emerging Markets), while $39 Billion has flowed out of Domestic Equity funds. So it seems the “ball is teed up” for European markets to finally reflect European economic potential.
We are leery, however, of getting too far ahead of the facts, given the political difficulties on display in Europe last year and today. While monetary stimulus should provide the spark needed for renewed recovery over the near-term, clearly Europe’s problems are structural as well. We have had an ugly reminder recently of the political vulnerability of the monetary union with Greece’s January election, which elevated a far-left, and anti-reform (and anti-ECB) party into power. In much of Europe, it is virtually impossible to fire or lay-off workers, thereby making it difficult for companies to adjust to changing economic conditions, or to attract the best talent (so what business owner would want to hire?). As a result, staggeringly high unemployment, particularly among the younger generations) is likely to remain stubborn without significant labor reform. Taxes in much of the Eurozone, particularly France, are also confiscatory. So while the markets may feel short-term relief from the ECB’s efforts, undoubtedly they will also be looking for more intra-member political cooperation to deliver structural reforms, and hopefully longer-term growth prospects. Fixed Income One of the most spectacularly “wrong” predictions for 2014 made by just about every market strategist we heard or read concerned the change in interest rates. While our own comments last January admitted we were more positive on bond prospects for 2014, we identified last year’s ~3.00% rate on the Ten year Treasury as more “normalized”. We believed this to be the case, given the imminent end to tapering. Certainly no one we know of was expecting a 10.74% total return on this benchmark maturity (far above its coupon yield).
Today the ten-year stands at 1.75%–nearly half the yield of a year ago! Janet Yellen, Chairman of the Federal Reserve, is now openly speaking about a June to September time-frame for the first interest rate hike in the US. We will leave it to investors to decide if they think interest rates will stay below 3%–and even 2%, in perpetuity. We advise against forecasting the past, despite its having been prologue in 2014. For those who take the Fed at face value, we think the graph to the left could be instructive in shaping expectations of a 30%, 50% or higher bond allocation when rates actually do begin to rise. We’ve written extensively about the bond market in years past and we understand the topic generally elicits a collective yawn among many of our clients.
Ultimately, we think investors are forced to choose between the boogey-man of actually rising interest rates, or the boogey-man of a 100% credit-bond portfolio—which will likely increasingly correlate with the stock market. Bonds are universally viewed as the most expensive asset class in the capital market universe by both measures: yields and spreads (at, and near historic lows, respectively). These valuations have not prevented bonds from becoming more and more expensive in recent years. This reminds us of real-estate, or even “dot-coms” not long ago.