Market Perspective Full Year 2008
2009 Outlook and 2008 Scorecard
In an environment that was not just risk-averse but avoided risk like the plague, it came down to this: If an asset was backed in some form by the U.S. government in 2008, it produced positive returns. Everything else -- literally -- lost money. In many cases, these losses were of historic proportions. Intermediate-term treasury bonds were up 10.4%, near their historic highs, and longer term governments performed even better, while U.S. stocks suffered their worst returns since the 1930s (U.S. large-caps down 37.0%, and small-caps down 33.8%). Foreign stocks fared even worse, with developed-country equities falling 43.4% and emerging-market stocks plummeting just over 55% -- in both cases their worst annual performance on record.
The more shocking thing about 2008, however, was not that global stock markets fell at the same time. It was that high-quality, fixed-income categories failed to follow the rally in government paper, thus depriving investors of gains that in typical bear markets may have at least partially offset their stock losses. For example, bonds became the safe haven for many investors in the increasingly risk-averse latter part of 2007, and investment grade bonds accumulated good and even very good returns by yearend. In 2008, ravaged by the credit crisis and flight to U.S. Treasuries, intermediate investment-grade corporate bonds fell 2.8% and high-quality municipal bonds dropped nearly 3%, in both cases their worst performances since 1994. Even money markets suffered a brief scare in the wake of the Lehman Brothers bankruptcy in early October.
Also shocking was the speed at which events unfolded. The U.S. stock market lost about 40% of its value in just nine weeks of mid-September to mid-November. And stocks had no monopoly on volatility in 2008, as credit markets and economic indicators such as oil prices, employment, and inflation fluctuated with a violence higher than anything in recent memory. Never has so much wealth disappeared so quickly across such a wide variety of asset categories.
Economic Review
The major economies of the Western world are now completely mired in recession. According to the National Bureau of Economic Research, the U.S. officially entered at the end of 2007; this past November the 15-country Euro zone ushered in its first recession since 1999; and the U.K. declared the start of its recession just a few days ago. Meanwhile, China’s economic growth was faltering as 2008 ended, and the reverberations were being felt in many parts of both the emerging and developed world.
As we have reported, economists estimate that U.S. consumer spending accounts for about 70% of business activity in this country. Thus, our slumping economy comes as no surprise in the sense that for years, many economists had predicted U.S. consumers would falter amid a mix of heavy debt, meager inflation-adjusted income growth, and budgets increasingly consumed by health care and other rising costs. But time and again, consumers proved resilient, even treading water in 2007 and the first half of 2008 as housing prices plummeted and gasoline prices spiked. However, in the fall of 2008, U.S. consumers cried "uncle." With troubled debt markets choking off credit, big-ticket purchases of everything from homes to autos sank to multi-year lows. Consumer spending dropped 3.8% in the third quarter (on an annualized basis), the biggest decline since 1980, and the fourth quarter was likely worse.
The impact on U.S. employment of the continuing housing slump and the sharp drop in consumer spending has been fierce in 2008. The loss of just over 2.5 million jobs was the worst since 1945, and the unemployment rate reached 7.2% in December. Job losses spared no region or sector, except for small increases in education and health care services and government, and most observers feel the unemployment rate doesn’t count many out of work. By contrast, U.S. employment grew by about 2.4 million in 2006 and approximately 1.3 million in 2007. Indeed, the problems on Wall Street in 2007 have clearly spilled over onto Main Street in 2008.
Popping of the U.S. housing bubble and other related phenomena, such as creative financing, borrower fraud, and secondary marketing of packages of loans whose risks were far greater than presumed, have all been well chronicled in the media. The result has been a dramatic reduction in the availability of home financing, which has severely contracted home demand, as well as huge increases in mortgage defaults, which have hurt financial institutions and created an additional supply of homes for sale on an “involuntary” basis. During 2008, new home sales tumbled to their lowest level in 17 years. Given excess inventory, housing starts dropped by about 19%, to an annual rate of 625,000, a record low dating back to 1959. Permits, which gauge future starts, fell to a 616,000 annualized pace, also a record low.
At mid-year in 2008, oil prices reached record highs near $150 per barrel and U.S. motorists grappled with $4 a gallon gasoline. The Fed stopped lowering interest rates due to concerns about inflation. Food and other commodity prices also surged, causing the U.S. government's consumer price index (CPI) to rise 5.5% in August (on a year-over-year basis), the highest inflation rate in 17 years. Then the financial crisis reared up, the global economy went into a tailspin, and oil prices slumped nearly 70% to $44 per barrel, while gasoline fell to $1.70 per gallon. Four months after posting a two-decade high, the CPI declined nearly 2% in November (from the month before), the biggest monthly price drop of the post-war era. CPI declined another 1% in December and ended 2008 at a negligible .1% increase for the year. The good news is consumers just received a massive stimulus injection in the form of cheaper energy prices, and the Fed resumed rate cuts with abandon. The bad news is deflationary forces have reared their ugly head and are a serious threat in 2009.
Though the U.S. suffered through its housing bust and credit crunch in the first half of 2008, most of the rest of the global economy appeared to be holding up fairly well. Many emerging-market countries hummed along, with China continuing its double-digit growth and commodity exporters from Russia to Brazil enjoying the boom in raw materials prices. But when the U.S. credit crunch became an all-out financial crisis and U.S. consumer demand dropped off a cliff in the fall, the contagion reverberated quickly around the globe. Credit dried up as global investors fled risk, and exports plummeted amid flagging demand. The once-trendy notion that foreign economies would "de-couple" from U.S. weakness was laid to rest.
China’s economic growth rate fell sharply in the fourth quarter, sapped by weakening investments and exports that signal rockier times ahead for the world’s third-largest economy, as well as the many nations that have come to rely on it. The Chinese government recently reported that its gross domestic product, or economic output, rose 6.8% in the final quarter of 2008 from a year earlier. That was the lowest quarterly growth rate in seven years and a marked slowing from the previous quarter’s 9% advance. The deceleration dragged down the country’s annual growth to 9%, well below the 13% increase for all of 2007. China’s exports, which had been booming month after month by 20% to 40% in recent years, contracted in November and December as orders fell sharply from ailing U.S. and European economies.
The U.S. dollar strengthened versus most major foreign currencies in 2008, including those of both developed and emerging markets. The dollar’s appreciation was counter-trend, because it has declined in five of the past seven years. The J. P. Morgan Dollar Index indicated a 7.7% increase of the dollar versus 19 currencies of our major trading partners. The dollar’s 4.5% appreciation versus the euro was unspectacular, but it gained almost 38% versus the British pound and almost 25% versus the Canadian dollar. However, the greenback dropped against the Japanese yen and Chinese yuan. Its 14.6% fourth quarter drop versus the yen pulled its full-year decline to 19.5%. Against the Chinese yuan, the dollar declined approximately 6.3% in 2008, as the Chinese allowed their currency to gradually revalue upward during the first half of the year, but held it quite steady in the second half to maintain price competitiveness of the their exports. In 2007, the dollar decline had been 6.4%. Finally, the U.S. balance of payments deficit, though still high, was narrowing during 2008, caused by substantial decreases of U.S. imports resulting from the significant decline of U.S. consumer spending.
Maybe just as surprising as the speed with which things unraveled in the fall of 2008 was how promptly the Federal Reserve and the U.S. government moved to unveil what is potentially the largest and most broad-based economic stimulus effort in history. The Fed moved its target interest rate to an unprecedented low near 0%. It flooded the financial system with liquidity, doubling the amount of credit it provides to more than $2 trillion. The Fed promised to do even more, committing to purchase $800 billion of mortgage-backed securities, agency bonds, and consumer loans. Additionally, the federal government committed $700 billion to the Troubled Asset Recovery Plan (TARP), which included a massive recapitalization of the banking system, with promises to do much more in 2009.
Foreign central banks have been facing about the same dilemma as in the U.S. The Bank of England, the European Central Bank, the Bank of Japan, and the central monetary authorities in China have all instituted urgent programs to significantly ease credit and shore up financial institutions and consumer spending in an attempt to avoid economic stagnation and re-invigorate their economies.
Though there was much concern about the availability of home mortgages, rates actually declined for the second year in a row. They responded to the Fed’s actions, albeit slower and less than intended, and thirty-year fixed rates ended 2008 a bit below 5.0%, a five-year low.
All of the above descriptions of economic conditions and trends can be boiled down and referred to as a massive de-leveraging. Therefore, to conclude this section, we would like to remind the reader of our review of de-leveraging in our previous client letter dated October 19, 2008. As noted, de-leveraging involves shoring up the balance sheet, by asset sales and/or pay down of existing debt. The process is twofold. One is to increase liquidity and profitability/cash flow by removing bad assets which are illiquid, declining in value, and/or not producing income. The other is to pay down existing (excess) debt and/or replace it with capital funding so the burden of debt service is eased.
The first phase of this process began in mid-2006 in the U.S. housing sector. The biggest losers initially were home builders and real estate and mortgage brokers plus of course over-indebted homeowners. The next phase began in mid-2007 with the realization that values of many mortgage-backed securitized assets were seriously impaired by rising foreclosures and previous excessively easy credit. At this point, the housing meltdown was spreading to other countries. Also, excessive leverage by numerous lending and investing institutions in the U.S. and abroad became apparent and was acknowledged as a potentially fatal condition in combination with declining asset values. Credit seized and bank loans evaporated. In the next phase, in mid-2008, the U.S. consumer retrenched, or cried uncle as described above, overcome by increasing job losses and a decimated net worth as home and stock portfolio values declined dramatically. By the fall of 2008, it was clear that domino effects and feed-back loops due to increased globalization had infected the whole world with quite extreme economic challenges.
Equity Review
The broad U.S. stock market lost 37.3% in 2008 as measured by the Wilshire 5000 Index; by comparison, this loss was almost as much as the index lost over three negative years during the 2000-2002 bear market. The S&P 500 Index of blue chip stocks was down 37.0%, and the Russell 2000 Index of small-cap stocks lost 33.8%. The MSCI-EAFE Index of large developed country foreign stocks was even worse, providing a negative total return of -43.4%.
The flip side of the violent sell-off was that it pushed down the valuations of many asset categories to levels not seen in years, decades, or in some cases, ever. U.S. stocks reached a price-to-earnings (P/E) ratio of about 13, nearly half the average of the past two decades. Foreign P/E ratios, for both developed countries and emerging markets, reached their lowest levels in more than two decades (9 and 8, respectively).
In 2008, by a variety of measurements, U.S. financial markets were at their most volatile since the Great Depression. Nearly 17% of all trading days for U.S. stocks -- almost one a week -- ended in a move that was 3% or more (either up or down) compared to the beginning of the day. Prior to 2008, the highest percentage of three-percent-move days during the past 70 years was 7% in 2003, meaning 2008 was more than twice as volatile as anything since the late 1930s. And while many of those days were negative, 2008 was the first time since the 1930s the U.S. stock market went up 10% or more in a single day -- and it did so twice.
Among the more common ways to differentiate among stocks is by size (larger capitalization versus smaller) and by style (value versus growth). Because the 2008 sell-off was so broad and practically indiscriminate, size and style differences were rather insignificant for the year. For the full year, growth style indices were slightly worse than value style indices, but the difference was only about two percentage points. Large-cap stocks are measured by the Russell 1000 Index, and they underperformed small-cap stocks as measured by the Russell 2000 Index. Ignoring style considerations, large-caps lost 37.6%, and small-caps lost “only” 33.8%. Again, the difference is relatively small. The higher performance of small caps had characterized markets since the Internet Bubble burst in 2000, and this year’s results represent a continuation of that pattern.
Results for mutual funds were about the same as indices, though differences were somewhat greater. Large-cap value funds beat large-cap growth funds by about 6 percentage points. Similarly, small-cap value funds outperformed small-cap growth funds by about 8 percentage points. The preference for value stocks has also persisted since the Internet Bubble burst in parallel with the small-cap preference noted above. Please note that classifications of mutual funds by style have their limitations.
Longer-term data reflect the extent of the 2000-2002 bear market correction and the deep 2008 slump, especially among larger capitalization and growth-oriented stocks. The table below covers two bear markets and one bull market (2003-2007) and shows annualized nine-year returns for 2000 – 2008:
Value |
Growth |
|||
Large Cap Mutual Funds |
-0.5% |
-7.0% |
||
Small Cap Mutual Funds |
5.7% |
-3.1% |
As noted previously, value stock returns should equal or exceed growth stock returns, and small cap returns should equal or exceed large cap returns in the long run. The unwinding of the tremendous disparity this decade between the performance of small value funds and large growth funds made some headway in 2007, but stalled in 2008 and may take many years to complete.
Comparing sectors, none escaped the carnage. Health held value best, losing about 23%, and the energy and commodities sector was an extreme roller coaster. Natural resources stocks were far and away the best at mid-year, but ended the year as the worst performing sector due to the huge turnaround in energy and commodities price in the summer and fall.
In 2008, the weak returns for broad, capitalization-weighted market indexes were indeed representative of performance at the level of individual stocks. For the three U.S. stock exchanges combined, 715 stocks advanced and 7,006 stocks declined. The corresponding advance/decline ratio of .10 lands not only at the bottom of the 19-year period we have been tracking, but also stands far apart from the previous low of .52 in 1994.
As reviewed in the past, the advance/decline ratio has its limitations. Nonetheless, the extremely low value of the advance/decline ratio in 2008 provides some hope that U.S. stocks may bottom and recover soon.
2007 was the fifth straight year foreign stock markets generally outperformed the U.S. market, but this streak ended in 2008. As indicated above, the U.S. dollar appreciated throughout 2008 and gained about 7.7% verses 19 currencies tracked by the J.P. Morgan Dollar Index. For U.S. investors, local foreign returns were decreased by this strengthening of the dollar. As indicated in the data table on the next page, the average mutual fund investing in international stocks lost 44.6% for the year, a bit worse than the MSCI EAFE return of -43.4% in U.S. dollars. The MSCI EAFE Index covers developed markets outside of the U.S. and Canada.
Emerging markets stocks were some of the worst performers in 2008. Stock price appreciation had been so dramatic in emerging markets that corporate earnings growth, though very strong, had not kept up. As a result, overall price/earnings ratios of emerging markets were very high, and their stocks were very vulnerable to economic problems in 2008. An additional major cause of reversal was the collapse of commodities prices, which particularly hurt Russia, Brazil, and Venezuela. China and India saw a contraction of overseas trade due to decreasing orders from strapped Western and Asian customers. The MSCI Emerging Markets Index lost 55.1% in U.S. dollars and a somewhat better -47.2% in local currencies. Over the previous five years, emerging markets stocks had provided a spectacular return of 33.6% per year in U.S. dollars.
Global stock returns are summarized in the following table; please see footnotes for enhanced understanding:
| ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
The preponderance of negative five-year returns is both noteworthy and disheartening.
Stock Fund Managers Versus Indexes
Active U.S. stock pickers lost to the S&P 500 Index in 2008, meaning they have beaten a passive or indexing approach for seven of the past ten years. This result was particularly surprising given that small caps, which are usually favored by stock pickers and typically comprise a higher allocation of fund portfolios than found in capitalization-weighted market indexes, had better results than large caps for the year. A detailed explanation is beyond the scope of this review. As reported above, active international stock pickers also modestly underperformed the EAFE index of developed country market returns. The underperformance may have resulted primarily because most diversified foreign funds include some emerging market stocks, which had very poor returns for the year. Finally, it is noteworthy that active stock pickers were unable to overcome fees for management of typically 1-2% per year versus zero cost for indexes.
Alternative Strategies
The six openend funds we used during most of 2008 provided a weighted average return of about -13.7% for the year. Consistent with their hedged, defensive positioning, their returns were significantly better than the returns of global stocks but were substantially below those for global bonds. For a typical Caves & Associates portfolio, the inclusion of alternative strategies produced an increase in 2008 return of about 3.1% (310 basis points) for the money committed to alternative strategies plus an increase in stability due to limited correlation of results with stock and bond markets. It should be noted that alternative strategies are particularly effective in down markets, and they had their best quarters compared with traditional asset classes when stocks were at their worst during 2008.
Results for indexes of hedge fund performance in 2008 compiled by Credit Suisse/Tremont, Hedge Fund Research, and Dow Jones were generally inconsistent and not helpful in evaluating performance of the six alternative strategy open-end funds. Results available to us for three private limited partnership programs employing unregistered hedge funds suggest the six funds had somewhat better returns than hedge funds, which one would expect because hedge fund managers employ at least some leverage. Leverage generally hurt results in 2008 when most bets were losers, not winners. As previously reported, hedge funds usually have a lower amount of assets under management, which aids flexibility and concentration into best ideas, both of which can benefit returns, but not last year.
Fixed Income Review
For bond funds, 2008 was both spectacular and disastrous. In the year’s first eight months, results in the U.S. were not particularly dispersed, but for the balance of the year, extreme risk aversion totally reshaped the bond markets. Treasury yields plummeted as prices rose when investors rushed to buy the safest assets during the near meltdown of the global financial system. As fears intensified, investors demanded to be paid much more for riskier investments. Accordingly, the difference between yields on corporate bonds and Treasury bonds widened sharply. Investment-grade corporate bond spreads hit their highest levels in at least three decades, while the yields on non-investment-grade corporates topped 22%. The prices of most bonds, which move inversely to yields, therefore declined significantly and dragged down returns on all but government bonds. The Barclay’s U.S. Aggregate Bond Index rose 5.2% versus a gain of 7.0% in 2007. This multi-sector, investment grade composite index hid great dispersion in a year that junk bonds were trashed and Treasuries treasured. For example, high yield bond mutual funds had an awful year due to the severely weakening economy; the 2008 return was a bleak -26.4%.
Returns for municipal bonds were hurt by continuing concerns over the financial health of several insurers guaranteeing many smaller issues and also by concerns of state’s and local municipalities’ fiscal struggles. Municipal bonds yielded more than Treasuries, without even factoring in their tax-exempt status.
Undeterred by currency losses for all but Japanese bonds, unhedged foreign bond investors found generally superior results by sticking to top quality. They earned 10.1% as measured by the Citigroup Non-U.S. World Government Bond Index, a result not too far from the very good 11.5% return in 2007. It should be noted that most foreign bond mutual funds allocate significantly less to Japanese bonds than the index, so they benefited much less from the strong appreciation of the yen versus the dollar in 2008.
The following table and footnotes present fixed income results:
| Annualized Return* | |||||
| One Year |
Five Years | ||||
| U.S. Bonds | |||||
| Barclays Intermediate Gov't Bond Index** | 10.4% | 5.3% | |||
| Barclays Intermediate Credit Index *** | -2.8% | 2.5% | |||
| Intermediate Municipal Bond Mutual Funds (National) | -2.2% | 1.7% | |||
| Short/Intermediate Municipal Bond Mutual Funds (CA) | -3.7% | 1.4% | |||
| High Yield Bond Mutual Funds | -26.4% | -1.9% | |||
| Foreign Bonds | |||||
| Citigroup Non-U.S. World Gov't Bond Index # | 10.1% | 6.0% | |||
| * | Mutual fund return data are from Morningstar. | ||||
| ** | Barclays index of U.S. Treasury bond total returns (i.e., interest plus or minus change inprice). Bonds in index have intermediate maturity of about 4-7 years. No mortgage-backed securities included. | ||||
| *** | Barclays index of U.S. investment grade corporate bond total returns (i.e., interest plus or minus change in price). Bonds in index have intermediate maturity of about 4-7 years. | ||||
| # | Citigroup index of total return of foreign government bonds issued by major developed foreign countries (Japan, Germany, France, and UK have the highest weightings). Returns are converted to US dollars. | ||||
Key Issues and Outlook for 2009
We don’t favor market predictions, especially in absolute terms. As you know, we argue that the future is unknowable. The interplay of socio-economic and geopolitical factors is just too complicated to predict. Thus, we are against trying to time the market. However, we usually try to identify factors and issues that are important in 2009 and beyond. These are typically historical macroeconomic waypoints and trends which can help us narrow the range of potential outcomes in the future. Examples involve such key factors as global economic strength, energy consumption and price trends, Chinese currency policy, the level of foreign investment in U.S. assets that allow us to finance our on-going balance of payments and Federal budget deficits (also known as the twin deficits), and relative valuations of major securities markets. In 2009, the list of issues is even greater, and developing an outlook is even more difficult than usual.
To save time, and because of the potential futility, we are presenting a condensed version this year. The reader is referred to previous years’ outlooks for expanded analysis and discussion of key issues.
The first key issue is the strength of the U.S. and global economy, an important issue every year. The future course of the global economy and the outlook for corporate profits will have a significant impact on global stock and bond markets. The issue boils down to two main questions, which have dramatically changed from last year due to all the negatives of 2008: 1) Will TARP, Obama’s planned stimulus program, and other past and future government actions end the U.S. housing slump, revive credit, restore confidence, and turn around the severely struggling U.S. economy, and 2) to what extent will key emerging markets economies, particularly China and India, manage to at least somewhat decouple from the U.S. economy so they can bolster world economic activity while Euroland and the U.S. recover from recession? If emerging economies continue to lose steam, China in particular, and Japan and Western developed countries enter into deep rather then mild recession, the global economy is certainly headed further downward, possibly into a multi-year spiral.
The second key issue for 2009, and a repeat from prior years, is the direction of the U.S. dollar. This issue is particularly murky. There are two major forces knocking heads. One is the on-going flight to quality, which strengthens the dollar. The other, and opposite, is huge deficit spending to stimulate our economy, which floods the world with new U.S. debt and, combined with on-going trade deficits, which require further demand for dollars, the two may require a cheapening of the dollar to entice adequate buyers.
The outlook for interest rates and the shape of the U.S. yield curve do not appear to be significant issues, but they may surprise. The Fed is expected to keep interest rates low indefinitely. Of course, global interest rates have their effect on overseas economic activity and the strength of foreign currencies versus ours. Further, the future strength of U.S. and foreign economies depends to a considerable extent on the moves of the various central banks, including the Fed, UK, EU, and Chinese authorities. Thus, we note the interrelated nature of these issues and the considerable difficulty in making projections involving both the dollar and interest rates.
Unfortunately, one very negative scenario to which we alluded above cannot be completely discounted. If foreign investors have a significant loss of confidence in our economy and the U.S. government’s ability to service its growing debt, we could experience the “mother of all credit crunches,” wherein foreign buyers demand much higher interest rates to buy and hold our debt. Further, especially later in 2009 or beyond, the Fed may need to increase rates if inflation becomes a threat, which could have various negative consequences for businesses and consumers.
As very evident in 2008, and intensifying into 2009, investor and consumer psychology will play an important role. As reviewed last year, the level of volatility in global financial markets for years had been very low until the latter part of 2007. For investors, this benign and profitable period encouraged not only complacency about risk but also an increasing appetite for risk. For consumers, they had (overly) easy access to credit and spent as if the good times would never end. However, as we progressed from mid-2007 through 2008, a number of inconvenient truths were revealed. They included awareness that we had achieved an unsustainable and somewhat artificial boom in real estate prices in the U.S. based on irresponsible, easy credit, and this artificial boom was also occurring to a considerable degree abroad; that much of the excessive pile-up of debt both here and in many developed countries, was indeed bad debt; that we faced the very real threat of global warming; and that we faced the on-going cost and challenges of fighting Islamic extremism and terrorism. In summary, these all converged to substitute fear and retrenchment for complacency and greed, and we witnessed a massive downward repricing of essentially all risky assets and associated market volatility.
The final key issue (every year) is the level of inflation and resource usage worldwide. At present, the higher risk appears to be deflation, but longer term, inflation could return as a consequence of the massive and expanding government stimuli being undertaken globally.
In considering these very difficult, interrelated issues, we are swayed, as usual, by what history reveals, namely, that economies and markets are cyclical and seek equilibrium and that investment results regress to the mean. Therefore, historical patterns and averages will ultimately prevail. The question is, when. Also, since the consensus outlook is already factored into current bond and stock price levels, how differently will the future unfold compared with the consensus?
Some of the smartest mutual fund management teams and economic/market prognosticators we know have had extreme difficulty formulating a view for the near-term future (6-18 months). There is just that much uncertainty at present! For this reason, and because we believe the future is unknowable, we are going to refrain from making a point-by-point 2009 projection. As we said in our previous, October 2008 client letter: “We cannot have much confidence in our ability to forecast the future in these almost completely unprecedented times.” Our best guess is that the current consensus forecast, though fairly negative, is still too optimistic. Accordingly, we are planning to position client portfolios in 2009 predicated upon 1) a risk averse, pessimistic outlook for the global economy, and 2) another best guess, that the future will unfold more negatively than the consensus has forecast. Therefore, stocks are still over-valued at present.
Another way to summarize our outlook is as follows. Last year, we predicted government stimulus would be adequate to avoid a deep bear market in 2008. It wasn’t. This year, as to government stimuli being timely and effective enough to prevent further weakness of equities in 2009, it won’t.
Over and over again, we have seen the unreliability of short-term economic and market forecasts and the unpredictable nature of markets. As usual, geopolitical risks could wreak havoc with these predictions, and there is always the risk of the totally unexpected. Therefore, results in 2009 could be considerably better or worse, or at least different, than indicated above.
Beyond 2009
We expect an economic recovery sometime in 2010 based on cumulative effects of previous stimuli plans and those to be implemented soon by the new administration in Washington. However, in many other respects, we have the same concerns expressed in previous years. They stem from the belief that the tax-cuts and deficit spree of the Bush administration, which have juiced up the economy, will exact a price in later stagnation. Additionally, it appears that the Obama administration will continue the same basic fiscal policy and even further add to deficits and the Federal debt. The various potential remedies for our growing debt levels and trade deficits are tax increases, spending cuts, and higher interest rates, in some combination. These remedies will all inflict pain, pain which we are currently deferring. Further, as some 77 million baby boomers begin to retire this decade, U.S. Social Security and Medicare will begin to move into the red as well, eventually by trillions of dollars. Some analysts predict no pro-growth strategy can make up such shortages and warn that mounting U.S. debt jeopardizes global financial stability.
According to Fed chairman Bernanke: “The longer we wait, the more severe, the more draconian, the more difficult the objectives are going to be” in responding to the crisis.
Unfortunately, the same Bernanke has just instituted much easier credit to “bail out” thousands on Wall Street, millions on Main Street, and multitudes of politicians who have failed to exercise appropriate financial/fiscal discipline. Given the depth of current economic challenges, it is clear we must postpone remedial action, but it is also clear we well have to face another day of reckoning in the not too distant future.
Implications for Asset Allocation
Because an outlook is to a considerable degree an attempt to have a crystal ball, the prognostications are very subject to error and need to be discounted. Nonetheless, many readers are aware we have recently taken what would be considered on a historical basis drastic actions for Caves & Associates; namely, we have moved to the downside from long-term targets for equities and tangibles by way larger amounts than ever before in our history. Our rationale is based on a perceived need to be conservative in the face of almost unprecedented economic and market conditions. We have taken actions to increase the emphasis on capital preservation while recognizing we could be wrong and we have compromised our commitment to the investment philosophy of avoiding market timing. Finally, we are letting our pessimism somewhat override our usual methodology of ignoring our outlook and maintaining portfolios quite near to long-term targets. Accordingly, we plan to maintain bond allocations not to far above long-term targets, but we plan to significantly underweight U.S. and international equities in order to hedge the risks of the weakening global economy. Additionally, we plan considerable overweighting alternative strategies because while they are defensive, they also have considerable upside potential to participate in any unexpected market recovery, which we know we could be incorrectly underestimating. We are bullish on oil and gas and other energy investments for the long run but plan to continue modestly reduced positions in tangibles stocks for the short run.
Relevance of Market Review and Outlook for the Strategic Allocator
Before concluding, let’s address the relevance of a
review and outlook and clarify why we are retaining “decent” exposure to
equities and are pursuing a partial substitution of alternative strategies for
equities rather than their wholesale replacement with cash and bonds, as
follows:
1. An outlook is really a best guess over 6-18 months, which is not a long-term period. Thus, most outlooks support tactical maneuvering for short-term gain. Most outlooks are also trend following, not contrarian. It is human nature to expect continuation of recent trends. It takes a brave soul to predict a reversal. We try to develop our outlook to avoid this common problem, but we are human, too.
2. As described in the Outlook Scorecard section below, our outlook is not too reliable. Thus, it is not a sound basis for big bets. We could make cohesive, plausible arguments for predictions that would be both much more negative and much more positive than those above.
3. Caves & Associates prepares a market review so we do not blindly follow history or ignore the markets. We also stay abreast of the latest research that might shed new light on historical bases for portfolio design. We monitor market trends, but mainly to be able to properly evaluate mutual fund managers’ performance and explain the performance of client portfolios. Finally, we prepare an outlook because the exercise has a small possibility of allowing us to foresee major problems requiring extraordinary strategies. Thus, it's prudent, and part of our responsibility to clients.
4. Asset allocation is a long-term approach utilized to manage long-term money according to long-term historical evidence. Asset allocation defined in this manner requires a disciplined adherence to a relatively fixed asset mix. It is also quite contrarian, because when an asset class proportion declines due to relatively poor performance, the asset allocator buys more. Hence, asset allocation entails periodically selling your winners and buying your losers to maintain the strategic balance. This rebalancing is done periodically and “religiously” and is definitely not “market timing” or “chasing performance.” Therefore, near-term outlooks are of limited interest to the strategic asset allocator.
NOTE: As described in the section above, we are delaying what would be a contrarian move to buy equities now, and we are not “religiously” rebalancing at this time.
Outlook Scorecard, Strategies Employed and Impact on Results
2008 was a year most investors would like to forget, but we’re sticking to our annual tradition of assessing Caves & Associates’ performance. Last year was the tenth time we attempted something resembling an outlook. A scorecard is in order to see if we are gaining anything from the effort.
Our past report cards have been generally favorable: we have had more predictions right than wrong, and our errors have not been harmful to returns. Unfortunately, we cannot say the same for our 2008 outlook and investment tactics. Notwithstanding, as detailed below, an occasional negative report card is inevitable for a firm such as Caves & Associates, which generally follows a non-timing, strategic allocation approach. Further, our outlook is always qualified because it puts considerable faith in sound decision-making by government officials. Additionally, the outlook assumes the absence of 1) major external shocks, and 2) no more than passing panic and irrationality among investors and consumers. Therefore, the poor scorecard is also explained by significant violation of these presuppositions, namely 1) poor government actions (for example, TARP has largely been a failure so far); 2) a major external shock, namely the severe, fundamental problems of the global financial system; and 3) a major panic on the part of many investors seeking safety at all costs.
Each year, at least one major surprise lurks. In 2004, it was the surprising strength of U.S. bonds; in 2005, the very unexpected strength of the U.S. dollar; and in 2006 the very strong U.S. corporate profits and stock prices notwithstanding the beginning of the housing downturn. Again in 2007, there were surprises, and as a result, many of our predictions veered off the mark by yearend. The main one, of course, was the rather calamitous surfacing of subprime mortgages as a financial disaster. A credit crunch quickly followed as fear and risk aversion took over for risk-taking and leverage.
To repeat the assessment of 2008 indicated above, it was the worst year in financial markets since the Great Depression; it was aberrational in almost every measurable way. There was only one recommendation that consistently made money, which was to sell everything and buy U.S. Treasuries. That’s the most defensive posture imaginable, and it could only have been the rare advisor who was suggesting such a radical, one-dimensional strategy a year ago.
Through the first eight months of the year, Caves & Associates’ outlook was faring pretty well, albeit already overly optimistic about equities. Then, markets went off a cliff in a cascade of crises and a complete loss of confidence, upending any diversified strategies, even defensive ones.
We’ll first review the forecast components which had a big, consequential impact on results and which really missed the mark. Then we’ll delineate various forecasts which both missed and hit the mark but were generally inconsequential for two main reasons: 1) they related to niche areas of client portfolios which received fairly modest allocations, and 2) we discount our predictions and execute quite small overweightings or underweightings pursuant to them. Thus, they produce only a small benefit when we are accurate or a small decrease in performance if we are wrong. Finally, we’ll relate the scorecard to our investment philosophy.
The 2008 Outlook indicated the negative impact of a weak U.S. economy on U.S. and foreign stocks had already largely occurred by the end of January 2008 (S&P 500 Index down 6.0% and EAFE Index down 9.2% for the first month of the year). In fact, the negative impact was enormous and gained momentum throughout the year, especially when combined with the crisis in the global financial system which increased risk aversion even more than in 2007 and culminated in very large losses in September, October, and November. Second, economic reports are making it clear that the U.S. recession has not been “mild,” as predicted by the Outlook. Third, the 2008 Outlook also got the direction of the U.S. dollar wrong. It forecast continued weakness, especially against emerging country currencies, whereas the dollar strengthened quite significantly versus most developed and emerging foreign currencies during the year. Fourth, the 2008 Outlook predicted continued strength in emerging economies. In fact, they did not “decouple” and have been experiencing a major slowdown along with developed economies. Finally, and based on the above, foreign stocks were forecast to have better performance relative to U.S. stocks, which also was not the case last year.
Perhaps the central error of the 2008 forecast can be identified and summarized as the prediction that the day of reckoning for financial markets and the U.S. economy had been postponed by simulative government actions in the second half of 2007. In other words, the Outlook assumed an increase in investor and consumer confidence, and in fact the exact opposite occurred and with little advance notice. Accordingly, so far, the 2007 stimulus programs and subsequent massive government actions in 2008 have been inadequate to stem the onslaught of negative news, financial losses, and broad declines in stock prices and lower quality bonds. Indeed, for countless companies like the Big Three automakers and AIG, quasi-government institutions like Fannie Mae and Freddie Mac, and leveraged debt investors, the day of reckoning did arrive.
To be clearer and cut a little deeper, we did initially position portfolios modestly defensively during the first part of 2008. We modestly overweighted bonds and alternative strategies and underweighted equities and tangibles accordingly. During the summer we increased fixed income and alternative strategies weightings, again modestly. The results were portfolios that moved from “modestly” to “somewhat” defensive. Nonetheless, as the extreme stock price declines of late September through November approached, we were maintaining equities and tangibles weightings at about 3-6 percentage points below long-run targets pursuant to our philosophy of disdaining market timing. In retrospect, this was inadequate hedging given the very sharp stock market declines that were to follow. Thus, sticking with our long-term, disciplined investment philosophy had a major negative impact on client portfolio values (and our own).
In conclusion regarding this part of the scorecard, we concede that we neither saw the magnitude of the financial crisis into which we were headed nor were we able to assess to what degree global stock markets were not yet reflecting the deteriorating financial system and economic conditions at the start of 2008 and even at mid-year. We certainly regret not dramatically underweighting stocks and the toll that declining markets took on client accounts.
As for fairly accurate predictions, the forecast for bonds was “unexciting but positive as long as one maintains high credit quality,” and the result was very much as expected. The forecast that inflation would “stay contained” has also come to pass because mid-year inflation has been offset by substantial price declines toward yearend. Finally, we might give the 2008 Outlook partial credit, because it forecasted a “mild but prolonged” recession. Indeed, prolonged is looking like the reality that will unfold.
During 2008, our management of foreign currency risk generally missed the mark, as suggested above. To start the year, essentially all foreign stock and bond positions were unhedged. Though not indicated clearly by the 2008 outlook, we believed developed foreign country currencies, like the euro, were getting overvalued, and we expected them to weaken after mid-year. On the other hand, we expected emerging market securities to hold value or continue their trend of appreciation versus the dollar. Thus, as a defensive move (which ultimately backfired), we significantly increased the allocation to unhedged emerging bonds at the start of 2008 (to PIMCO Developing Local Markets, PLMIX) and decreased the allocation to developed foreign bonds commensurately (partial sales of PIMCO Foreign Bond – Unhedged, PFUIX; and T. Rowe Price International Bond, RPIBX, which is also generally unhedged).
These tactics worked very well for the first half of 2008. PLMIX moderately outperformed PFUIX and RPIBX, and all three were solid performers, returning 4-6% for the six-months. Then, in July, we undertook a change which also enhanced returns: we replaced unhedged PFUIX with PIMCO Foreign Bond – Hedged (PFORX). When the flight to safety and the dollar subsequently raised the greenback versus foreign currencies, the exchange was beneficial by decreasing associated developed country currency losses in the second half of 2008. Unfortunately, the dollar also appreciated, and to a great degree, against emerging currencies, causing significant losses for PLMIX in the second half, which ended 2008 down about 15%.
What about foreign currency exposure for our international stock funds? During the year, they had unhedged exposure, and they did suffer currency-related losses. Here, our philosophy is to choose only unhedged funds for various reasons, mainly that they are always partially hedged against the dollar to the extent foreign companies have significant U.S. sales/operations. The upshot is we seek to manage foreign currency risk only respecting foreign bonds, and we “let” currency losses occur regarding international stock funds when the dollar rises, as in 2005 and 2008 (two years), in exchange for the benefit from currency gains when the dollar falls, as in 2002-2004 and 2006-2007 (five years). As a final comment, the dollar has been on a downward trend against the currencies of many of our major trading partners for decades, and we expect it to continue to fall long-term.
During the summer, we undertook another change which did enhance returns: we modestly decreased tangibles exposure, primarily by taking profits and deceasing oil and gas exposure before energy prices collapsed in the latter part of 2008. Notwithstanding, the operative word above is “modestly,” such that benefits to returns of the move was fairly inconsequential due to the smallness of the action, even though it was in the right direction. The benefit was further limited because oil and gas comprises a quite small percentage of client portfolios compared with the allocations to diversified U.S. and international equities. Additionally, we put a majority of the proceeds from sale of energy into a broad-based commodities fund which fared as poorly in the downturn.
One additional tactic was successful in 2008. We carried very low junk bond allocations all year. Thus, we largely avoided the deep losses incurred by low quality bonds.
Respecting a scorecard for the mutual funds we employ in client portfolios, they remained highly rated by and large. As evidence, Morningstar has just named its 2008 managers of the year (Morningstar is highly regarded for its mutual fund databases and mutual fund ratings). As in 2006 and 2007, one or more of the winners were well represented in the portfolios of Caves & Associates clients.
We believe the scorecard highlights why we recommend strategic asset allocation rather than tactical allocation or market timing. Over the long run, we are convinced that correct predictions will be largely offset by incorrect predictions, especially when the predictions have to deal with such a broad scope as global stock and bond markets. Thus, the effort adds little or no value but can reduce returns by increasing capital gains taxes, transaction costs, and management fees if the effort induces a short-term, tactical approach.
In a year of numerous, almost unprecedented surprises and what we deem unpredictable market weakness and turbulence, the inaccuracy of our 2008 Outlook becomes a moot point in the sense that an accurate, very negative outlook would not have dramatically changed the returns of portfolios supervised by Caves & Associates. That’s because the Caves & Associates philosophy of staying the course and disdaining market timing was the key determinant of investment performance of client portfolios in 2008. Pursuing this philosophy necessarily caused poor absolute performance in a year of such negative markets. On the flipside, if we underestimated future stock market strength, as we did in forecasting 2006 results, pursuing this philosophy meant clients did not miss gains as a result of being out of the market (or significantly underweight) because we generally “ignored” our forecast and maintained stock exposure that year.
Investors must take intelligent risks in order to be rewarded, and long term, stocks represent the best investment alternative. We know that markets go down, creating buying opportunities, and we must still be “in the game” when they inevitably go up.
Time is an investor’s best friend, and any year-end review is a snapshot of a short period. It may never be possible to properly assess how the Caves & Associates portfolio strategies fared in 2008. That’s because, if we had sold everything and moved into cash and Treasuries, we would have looked like heroes. However, the question would remain as to how timely in the future would we re-enter the riskier asset classes. Because markets move upward as rapidly as they move down, it is very likely we would linger too long in the perceived safety of the sidelines and miss much of the ensuing bull market run-up.