“Reversion to the mean” is a useful concept in investing. When we apply this concept to stock index valuation, this implies that there is a tendency for stock prices to trend higher when the market PE is well below the historical mean, and a tendency for stock prices to trend lower when the market PE is well above the historical mean. Reversions to mean valuations can take place over a long or short period of time, and it can happen by stock prices adjusting or by earnings adjusting. For example, one way for an overvalued stock market to revert to a more normal valuation level is for stocks to “grow into their valuation.” In other words, earnings growth could exceed stock price growth for a period of time, bringing valuations back into line with historical norms. Another Continue reading
One of the primary ways for an individual investor to gain a competitive advantage relative to the markets is to have a long term time horizon. When viewed through this lens, investors with a disciplined long term approach can benefit from short term market fluctuations systematically. An important way to benefit from market run-ups and sell-offs is through a process called rebalancing. Each client of Meritas has a customized Investment Policy Statement (IPS) that includes an asset allocation designed to meet their specific goals, needs and tolerance for risk. The equity, fixed income, and specialty funds in each portfolio have a tendency to perform differently from each other. This divergence of short term performance is what provides the opportunity for effective rebalancing. Here’s a simplified example to illustrate point. Let’s say that a client has a 30/30/40 target portfolio, 30% bonds, 30% stocks, and 40% specialty. Then, a selloff in the equity market causes the actual portfolio weightings to diverge from the target, and become 35/20/45. At that time, Meritas would expect to sell 5% of the bond positions and 5% of the specialty positions and add 10% to the stock positions in order to bring the actual portfolio back into balance with the target in the IPS. By following this rebalancing discipline, the positions which have outperformed are trimmed, and the proceeds are added to the asset class(es) that have underperformed. Taking the long term view with this disciplined approach is a way of implementing one of the first rules of investing, to buy low and sell high.
Traditionally, the investment advisory industry has recommended two main types of investments for client portfolios, equity (stocks) and fixed income (bonds). In most environments, high quality fixed income investments carry lower risk (as measured by price volatility) than high quality equity investments. To make a portfolio more conservative and less risky, a higher percentage of bonds is recommended, and to make it more aggressive, a higher percentage of stocks is recommended. A third category of investments has risen to increasing prominence over the past 20 years or so, going by the name of specialty fund or alternative investments. The category of specialty funds that we find most compelling at Meritas are those that seek to mitigate or decrease risk while generating additional returns per unit of risk that they are taking. Long/short funds are one example of specialty investments. Many specialty fund types appear first in the private Continue reading
The negative news about the economy continues and yet the stock market has kept going up. This divergence reinforces one of the key lessons of active management, which is that the broader the financial instrument, the less predictable the movement of its price. For example, let’s consider the shares of a single company, a very narrow financial instrument. Apple (AAPL) shares gained 90% in value from November 2011 to September 2012. From September 2012 until now, AAPL shares have fallen 40%. An active manager has to effectively analyze an enormous number of factors affecting the perceived value of AAPL in order to benefit from some of the rise in the share price and avoid some of the fall in price. If an active manager bought AAPL at a good time in the past 18 months, the value of the investment nearly doubled in less than a year. If an active manager bought AAPL at a bad time in the past 18 months, the value of the investment was nearly cut in half in less than a year. A concentrated, actively managed fund has 30 to 60 stocks in it, so in order to do well for investors, the manager needs to maximize good decisions and minimize bad ones. While the best active managers make some mistakes every year, it’s important to limit those mistakes in both quantity and magnitude. If the active manager’s expertise and skill are great enough, and their area of concentration is focused enough, they have the potential to add value to an investor’s portfolio. Now imagine a broader instrument, such as the S&P 500 index. The amount of factors affecting whether the value of the shares of Continue reading
The financial repression exemplified by the Federal Reserve’s zero interest rate policy (ZIRP), that was begun on Dec 16, 2008, has many side effects. One of these side effects is to drive down the interest income that savers and investors receive from their bond and fixed income investments. For example, many bank deposits are paying only 0.01% today. Similarly, locking up funds in a 5 year CD yields a paltry 1% to 1.5% today, which results in a negative return after inflation. In this yield starved environment, that recently entered its 5th year, having some skillful active bond managers in your portfolio can be very helpful in seeking to generate returns above the fund’s relatively low yields. The fund managers do this by trading bonds in addition to holding them. For example, a domestic corporate and government bond manager that we like is running a multi-billion dollar fund that is currently yielding just 2.54%. Last year, the fund generated a total return of 9.3%. The additional return beyond the yield came from a combination of realized gains on bonds sold throughout the year, plus unrealized capital appreciation of the bonds the fund holds. Similarly, an international bond fund that we like is currently yielding 5.6%, while holding approximately 50% of their $68Bn in cash and the other 50% in foreign government bonds. In 2012, the fund generated a 15.8% total return for investors, including both the interest income from holding bonds plus the returns from trading them.
(as of Feb 22nd, 2013)
The major U.S. equity averages have reached correction territory today, which is defined as a 10% drop from their recent high. The Dow Jones Industrial Average, Standard & Poor’s 500 and the Nasdaq all hit their highs of 2011 high on April 29th. From their peak, the DJIA is down 11.1%, Nasdaq 11.0% and S&P 500 12.0%. It seems to me that one major aspect of these sour economic times is the crowding out of the private sector by
a burgeoning public sector. Politicians on both sides of the aisle continue to be more interested in getting re-elected, and growing the size of government, rather than reducing the size of government and getting out of the way so that the private sector can thrive. In the private sector, success is determined by profits, and therefore costs must be managed or the business is a failure. In the government sector, there is no comparable accountability. Success is determined by how much money the politicians bring back to their district, or the size of the budget of their department or agency. In other words, in government, the larger your costs, the larger your success! That which would destroy a business, huge costs, are temporarily rewarded in government. Until the government’s astronomical costs bring down the entire economy.
Here is an article that lays out the massive expansion of government at the expense of the private sector under George W Bush, and the party that used to be proponents of small government.
With the increase we’ve seen in the debt ceiling this week, here is what the amount of indebtedness that our government is committing the American people to looks like in pictures.
This article from the St Louis Federal Reserve talks about the horrific loss of jobs in the recession of 2007-2009. 89 million jobs lost and 82 million gained for a net loss of 7 million jobs. Notice that the areas of job openings are concentrated in government or government related sectors such as healthcare and education.
As an 82 year old man who lived through the Great Depression said to me today, we are not in a recession, we are in a Depression.
Solving the nation’s problems is beyond the scope of our business. Awareness of the ever-changing domestic and global economic environment is our business because our mission is to protect and grow our client’s portfolios regardless of the direction of the economy. We continue to have defensively positioned portfolios for our clients due to the hostile business conditions that exist in the US and much of the global economy.
We specialize in selecting the right investments, buying them at the right price and combining them in such a way as to be defensive against market shocks like today, and the past 10 days. We like to sleep well at night and so do our clients.
We’ve analyzed recessions and market downturns going back to 1953. In that time, there have been 10 recessions, one every 5 to 6 years. You can see in Callan’s Periodic Table of Investment Returns that the sharpest rebounds in the stock market tend to occur in the first year following the end of a recession. Thus the old saying, buy when there is blood in the streets. 2009 was no exception with the Russell 2000 Growth Index skyrocketing 34.4% that year, after plummeting 34% in 2008. The run-up for the last 43 weeks of 2009 from the March lows, a moment of panic in which Warren Buffet said he had never seen a level of fear like it before, is a head spinning 127%. So, the equity markets have been on a tear for the bulk of the last 7 quarters in a row. What can we expect going forward?
In the Callan table, you will see 4 recession nadir years (1990, 1994, 2002 and 2008) in the past two decades that were each followed by a huge stock market rebound year. The resurgence years were 1991, 1995, 2003 and 2009. Ebullient equity markets lasted 2 more years, 4 more years, and 3 more years respectively, following the first three of these resurgence years. So, if the recovery that began in 2009 follows the pattern of the last three recoveries, we can expect 1 to 3 more years of buoyant equity markets before the next major downturn.
Bottom line: The headwinds continue to be significant, with intractable unemployment and huge public and private debt burdens plaguing the economy. But like Lance Armstrong on a steep mountain stage of the Tour de France, the markets love to climb a wall of worry When the problems are easily identified and widely noted in the media, that is often a good indicator that plenty of money remains on the sidelines waiting to come back into the equity markets and drive them higher. Thus, some judicious long exposure is warranted. With respect to the huge run-up that equities have experienced in the past 7 quarters, a healthy allocation of hedging in portfolios is also prudent at this time.