Market Perspective Full Year 2010 |
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Securities markets continued to rebound in 2010, extending one of the most impressive recoveries in the history of the capital markets. Global governments, and especially the U.S. government, used monetary policy to keep interest rates low to encourage corporations to spend and investors to allocate funds to risk-based assets. This accommodative monetary policy proved to be very successful in the short run as economies continued to recover and riskier assets appreciated substantially. Equities and fixed income securities posted positive returns. The average diversified U.S. equity fund returned 19%, and the average diversified foreign equity fund returned 12% according to Morningstar. The Barclays Capital U.S. Aggregate Bond Index rose 7%; credit-sensitive intermediate investment-grade and high yield bonds returned 8% and 15%, respectively. U.S. government bonds, the only asset class to produce negative returns in 2009, earned 5%. Finally, foreign government bonds provided a total return of 5%. Economic ReviewThe extraordinary measures taken by the U.S. and other world governments to revive the financial system and world economies seem to have achieved their desired short-term effects, most evident in the financial markets during the fourth quarter of the year. The U.S. economy, as measured by gross domestic product (GDP) expanded 2.6% during the third quarter of 2010, 1.7% during the second quarter, and 3.7% for the first quarter following expansions of 1.6% and 5.0% during the third and fourth quarters of 2009. The U.S. economy continued to show signs of improvement during the third and fourth quarters with the manufacturing segment leading the way. The Manufacturing ISM Index ranged from 54.4-60.4 during 2010 and finished the year at 57.0 in December. The Non-Manufacturing or Service ISM Index improved from 50.5 in January to 57.1 in December. Readings above 50 indicate that the economy is generally expanding while readings below 50 indicate a contracting economy. December was the 17th consecutive month of growth in the manufacturing sector, the 12th consecutive month for the service sector, and the 20th straight month of expansion in the overall economy. The past relationship between the annual average for the Manufacturing Index and the overall economy indicates a 5.1 percent increase in real GDP for 2010. The Federal Reserve Board reported in its January Beige Book that "economic activity continued to expand moderately from November through December." The trend of consumer spending is unclear. Consumer spending is important, as up to 70% of the economic growth in the U.S. has historically been driven by the consumer. The Consumer Confidence Index was 52.5 in December compared to 52.9 a year ago. The Reuters/University of Michigan Sentiment Index was 72.7 in January 2011, well below the 86.1 average for the last decade, but higher than six of the last seven months. Finally, the Consumers Expectation Index, a measure of how individuals feel about their finances six months in the future, increased to 68.2 in January 2011, the highest mark since June 2009. The employment situation improved a little during 2010. According to the Bureau of Labor Statistics, 1.1 million non-farm jobs were added to payrolls during 2010, including 210,000 in October, 71,000 in November, and 103,000 in December. Manufacturing, mining, health care, retail trade, leisure and hospitality, and temporary help services added jobs, while construction continued to lose jobs. Unemployment was 9.4% in December 2010 compared to 9.9% at the end of 2009, a disappointingly low improvement and a cause for stepped-up government stimulus plans (see below). Housing markets were supported by an $8,000 tax credit for first-time home buyers though the first half of 2010, dropped precipitously during the third quarter, and slowly began to improve during the fourth quarter. The outlook for housing markets in 2011 is uncertain. According to Fannie Mae Chief Economist Doug Duncan, "we can expect a small rise in home sales this year, but significant amounts of supply and shadow inventory of expected foreclosures will continue to hamper a robust housing picture for some time." Inflation remained low in 2010 as the rate of increase in the Total Consumer Price Index (CPI) slowed to .5% and the Core CPI (excluding food and energy) rose 0.8%. The deceleration in Total CPI was primarily due to the gasoline index, which rose 13.8% in 2010 after rising 53.5% in 2009. Although U.S. government stimulus plans are expected to lead to higher inflation over the long term, on-going unemployment and subdued inflation allowed the Federal Reserve to keep short-term interest rates close to zero for the year. In November 2010, the Fed also announced a plan to keep longer-term interest rates low through its purchase of $600 billion in longer-term U.S. Treasuries through June 2011. The program has been named QE II, and follows long-term bond purchases of approximately $1.7 trillion in 2008-09 as part of QE I. Finally, in mid-December, Congress reduced the payroll tax by 2 percentage points for employees in addition to extending the Bush tax cuts for two more years. Large cash reserves and financially solvent banking systems that avoided the leverage problems in the U.S. and other Western countries positioned emerging market countries to take full advantage of the global rebound. Asia's fast growing economies continued to expand in 2010. China's GDP is estimated to have grown 10% during 2010; India expanded 7.5%, and Southeast Asia, including Indonesia, Vietnam, Hong Kong, Taiwan, and Thailand, grew at 6%. Most of this expansion in GDP reflects Asia's emerging countries' growing manufacturing capability and expanding domestic markets. Last year's GDP growth is estimated at 4.0% for Latin America, 4.4% for the Middle East, and 4.1% in Africa for 2010. In Europe, economic growth slowed modestly during the third quarter, and fourth quarter data indicate that while Europe's economy is still expanding, its rate of growth has moderated a bit. According to Eurostat, the statistical office of the European Union, Euro area GDP increased by 0.3% in the third quarter and 1% in the second quarter, as governments' austerity measures to cut record budget deficits dented the recovery. The region's growth has been somewhat uneven. The German economy has been strong, outperforming the rest of the region considerably, while France continued to grow at a faster pace than the region's average. Output growth for the rest of Europe, however, has slowed substantially. In Japan, the government estimates fiscal 2010 GDP of 3.1% will slow to 1.5% in fiscal 2011 in spite of a gradual recovery in the global economy because Japan's economy will no longer benefit from a series of government fiscal stimulus measures in 2010 that boosted domestic consumption. It is noteworthy that Japan's economy suffers from government debt limiting the government's and central bank's options to stimulate the economy, crippling domestic deflation prompting consumers to delay purchases, and shrinking exports as a strengthening yen makes Japanese products more expensive overseas. Equity ReviewResults were strong both here and abroad for U.S. dollar investors. The broad U.S. stock market gained 17.9% in 2010 as measured by the Wilshire 5000 Index (equal-weighted). For U.S. dollar investors, the MSCI EAFE Index of large developed country foreign stocks was up 7.8%, the pan-European Dow Jones Stoxx index of Europe's 600 biggest companies rose 5.0%, Germany's DAX index gained 16.1%, and Britain's blue-chip FTSE 100 index rose 9.0%. The MSCI Emerging Markets Index was up 18.9%, the MSCI Latin America Index rose 12%, and the MSCI AC Asia Ex-Japan Index gained 19.9%, also in U.S. dollars. The rapidly strengthening yen turned a loss of -1.2% in local currency into a 15.4% gain for U.S. dollar investors, according to the MSCI Japan Indexes. According to Morningstar, at the end of 2010, the average diversified U.S. equity fund was trading at a price-to-earnings (P/E) ratio of 16.3. The average diversified foreign developed stock fund was trading at 14.2. Surprisingly, emerging countries stock funds were trading at 15.0. Emerging stocks traditionally trade at lower P/E ratios than those of foreign developed countries stocks due to the perceived additional risks of investing in emerging markets. Perceptions may be changing, and the divergence of growth rates is clearly also instrumental in the higher emerging markets valuations. The year 2010 included two completely contrasting time intervals for U.S. stock returns, as shown by the following table:
The sectors that gained the most in 2009 were also big gainers in 2010. Virtually all U.S. stock sectors provided double digit returns for the year. Technology (20.8%), communications (19.1%), real estate (27.0%), and energy and other commodities (18.2%) were the biggest gainers, but financials (10.9%), and health (8.2%) stocks also provided excellent, albeit lower returns. Among the more common ways to differentiate among stocks is by size (larger capitalization versus smaller) and by style (value versus growth). Large-cap stocks are measured by the Russell 1000 Index and small-cap stocks are measured by the Russell 2000 Index. Ignoring style considerations, large-caps gained 16.1% and small-caps gained 26.9%. This year's results once again followed the pattern of higher performance of small caps that has characterized markets since the Internet Bubble burst in 2000. For the full year, growth style indices modestly outperformed value style indices. However, value style indices outperformed growth style indices by 3.0 percentage points during the first half of the year but underperformed value style indices by 4.6 percentage points over the second half of the year. Results by style for mutual funds were about the same as indices, though variations were somewhat smaller. Large-cap growth funds beat large-cap value funds by about 2 percentage points. Similarly, small-cap growth funds outperformed small-cap value funds by about .6 percentage points. The preference for growth stocks was a repeat from 2009 but with significantly smaller outperformance. Before 2009, a preference for value stocks had persisted since the Internet Bubble burst in 2010. Like the representative indices, the average diversified small cap fund dramatically outperformed the average diversified large cap fund (14.5% versus 26.4%, respectively). Please note that classifications of mutual funds by style have their limitations. Longer-term U.S. stock data reflect the deep 2008 slump and the extent of the 2000-2002 bear market correction, especially among larger capitalization and growth-oriented stocks. The table below covers two bear markets, one bull market (2003-2007), and the 2009-10 rebound, and shows annualized eleven-year returns for 2000 – 2010:
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, stalled in 2008, progressed considerably in 2009, and continued again in 2010. In 2010, the strong 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, 5,312 stocks advanced and 1,935 stocks declined. The corresponding advance/decline ratio of 2.75 places fourth, yet above the 1.80 mean and 1.45 median, in the 21-year period we have been tracking. As reviewed in the past, the advance/decline ratio has its limitations. Nonetheless, the moderating value of the advance/decline ratio in 2010 after an extremely high value of 4.09 in 2009 provides an opportunity for U.S. stocks to continue to appreciate over the next year. For example, after rocketing up to 7.19 in 2003, the advance/decline ratio fell to 1.72 in 2004. Notwithstanding, stock returns in 2004-06 were solidly in the black. Foreign stock markets generally underperformed the U.S. market in 2010, especially in local currencies. In U.S. dollars, however, currency gains and losses varied widely among foreign developed countries, resulting in varying results for U.S. dollar investors. The U.S. dollar gained about 1.5% verses 6 currencies tracked by the U.S. Dollar Index, primarily due to gains against the euro and British pound; the dollar fell against the Canadian dollar, Japanese yen, and Swiss frank. Against emerging markets currencies, the dollar declined significantly. For U.S. investors, foreign returns in local currencies were decreased by the currency gains associated with any strengthening of the dollar, and vice versa when the dollar depreciates. The average mutual fund investing in international stocks gained 11.9% for the year, significantly better than the MSCI EAFE return of 7.8% in U.S. dollars. The MSCI EAFE Index covers developed markets outside of the U.S. and Canada. Emerging markets stocks also provided excellent returns in 2010. The economies of emerging countries are growing faster than those of developed countries plus emerging countries have accumulated enormous cash reserves which can be invested to promote economic growth. The MSCI Emerging Markets Index gained 16.4% in U.S. dollars, boosted by currency gains due to the weakening U.S. dollar versus emerging market currencies noted above. Over the previous five years, emerging markets stocks have provided a solid return of 10.3% per year in U.S. dollars, as measured by the MSCI Index, notwithstanding catastrophic losses in 2008. Looking at global stock performance over the past five years, as measured by mutual fund returns, other salient observations are:
Global stock returns are summarized in the following table; please see footnotes for enhanced understanding:
* Mutual fund return data are from Morningstar. ** Capitalization-weighted index of 500 very large U.S. companies. The 500 are chosen to achieve a fair cross-section of U.S. industrial and service sectors. Recent median capitalization of approximately $48.2 billion. *** Barclays index of U.S. Treasury bond total returns (i.e., interest plus or minus change in price). 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. # Index of small U.S. companies. Recent median capitalization of approximately $1.0 billion. Somewhat overweighted toward financial stocks. ## International stock index indicating return of large foreign companies of 21 major developed countries (Japan, UK, and Germany have the highest weightings). Returns are unhedged and converted to U.S. dollars. No emerging market stocks are included. Stock Fund Managers Versus Indexes Active U.S. stock pickers beat the S&P 500 Index in 2010, meaning they have beaten a passive or indexing approach for nine of the past twelve years. This result was not 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, significantly outperformed large caps for the year. A detailed explanation is beyond the scope of this review. As reported above, active international stock pickers also beat the EAFE index of developed country market returns. This outperformance probably had two causes. First, it resulted because most diversified foreign funds include some emerging market stocks, which had excellent returns for the year. Second, as with U.S. small caps, foreign small caps typically comprise a higher allocation of fund portfolios than found in capitalization-weighted market indexes, and foreign small caps significantly outperformed foreign large caps for the year. Finally, it is noteworthy that active stock pickers were able to overcome fees for management of typically 1-2% per year versus zero cost for indexes.Alternative StrategiesThe six open-end funds we used during 2010 provided a very disappointing weighted average return of about 2.9% for the year. Consistent with their hedged, defensive positioning, their returns were significantly worse than the returns of global stocks but were also below those for global bonds. We note that our funds' performance was not particularly worse than for the category as a whole, which Morningstar calls Long-Short. The category gained 4.2% in 2010. For a typical Caves & Associates portfolio, the inclusion of alternative strategies produced a decrease in 2010 return of about -8.7% (870 basis points) respecting the money allocated to alternative strategies but 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 quarter compared with traditional asset classes when stocks were at their worst during the second quarter of 2010. Looking at results covering the last three years of high market volatility, the six alternative strategy funds provided a three-year return of about .6% (cumulative; not annualized). For a typical Caves & Associates portfolio, the inclusion of alternative strategies therefore produced a decrease in the cumulative 2008-2010 return of about -9.8% (980 basis points) for the money committed to alternative strategies, including the impact of compounding. Most of this cumulative detriment occurred in the 2010 underperformance reported above. Again, the inclusion of alternative strategies helped smooth client returns and thereby helped them "hold the course." However, this "benefit" did not offset the high opportunity cost noted above. We are re-evaluating our use of alternative strategies funds overall, the representativeness of 2010 results, and the weightings of each of the six funds in the group. Fixed Income ReviewFixed income performance varied notably across investment markets during 2010 with investment grade and high-yield bonds moderately outperforming U.S. Treasuries. Although the Federal Reserve held short-term interest rates near zero throughout 2010 and intermediate- and long-term Treasury interest rates fell through September 2010, during the fourth quarter, intermediate- and long-term rates began a steep increase on inflation fears and the need to attract buyers for large new issues of debt due to the government's funding needs for foreign wars and substantially expanded stimulus programs. And since bond prices move inversely to interest rates, prices on "risk-free" government bonds began to fall in the fourth quarter. Notwithstanding large price declines during the fourth quarter, long-term government and long-term investment grade bond funds returned a positive 11.9% and 11.0% including interest income for the year, respectively, according to Morningstar; the two categories of bonds had achieved quite high year-to-date returns for the first nine months. Intermediate-term government and investment grade bonds produced more modest returns of 5.0% and 7.8%, respectively, for the year. High yield bond funds rose 14.0% during 2010. Municipal bonds also provided positive returns for the year. However, they were lower than usual because enormous budget deficits facing state and local governments drove bond yields up and prices down during the fourth quarter. Reflecting investors' fears of potential bond defaults by municipal bond issuers and increasing risk premiums, long-term and intermediate-term California municipal bond funds returned 1.7% and 2.1%, respectively, for the year according to Morningstar, including tax-free interest earnings. It should be noted that effective returns to investors will be higher and depend on each investor's tax bracket. Unhedged foreign bonds received a boost in returns due to the weakening of the dollar during the year. The government bonds of major developed countries returned 5.2% in U.S. dollars for the year, as measured by the Citigroup Non-U.S. World Government Bond Index. Demand for the bonds of emerging markets remained high due to the relatively strong economic advantages discussed previously. Emerging market bonds returned 12.2% in U.S. dollars for the year, as measured by the JPM Emerging Markets Bond Index. The following table and footnotes present fixed income results:
* Mutual fund return data are from Morningstar. ** Barclays index of U.S. Treasury bond total returns (i.e., interest plus or minus change in price). 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. ## J.P. Morgan index of total return of debt instruments issued by 13 emerging markets countries (Argentina, Brazil, and Chile have the highest weightings). Returns are converted to U.S. dollars. Key Issues and Outlook for 2011We 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 try to identify factors and issues that are important in 2011 and beyond. These have been 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, rates and markets hitting all-time highs and lows, the monetary and fiscal policies of the governments of major economic powers, and relative valuations of major securities markets. In 2011, the list of issues reminds us of last year. We have the continuing tug of war between consumer de-leveraging (negative for businesses and markets) versus massive U.S. government economic stimulus (positive, at least in the short run). Additionally, 2011 brings the implementation of increased government regulation of business and consumer protection. Finally, the 2010 Tax Relief Act expires in only two years and at the time of the next Presidential election. This raises the possibility that tax and spending policy conflicts will be accelerated into 2011 rather than awaiting the election year, thus adding further uncertainty. As a consequence, developing an outlook is even more difficult than usual. To save time, and because of the potential futility, we are again 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 is a major determinant of corporate profits and will therefore have a significant impact on global stock and bond markets. Of course, there are no guarantees, but the unexpected expanded U.S. government stimulus that was part of December's Tax Relief Act ends the threat of a double-dip recession in 2011, to our way of thinking, and paves the way for a considerably stronger U.S. recovery, albeit still largely jobless. We also expect key emerging markets economies, particularly China, India, and Brazil, to remain decoupled from the weak economies of Europe and Japan. For at least a while, the world will benefit from two major economic engines while Euroland and Japan continue to recover from life support. The second key issue for 2011, and a repeat from prior years, is the trend of corporate profits. The increasing global economic strength just described should support a continued uptrend of corporate profitability. A third issue is whether the dramatic global stock price rebound over the last 22 months is justifiable and sustainable. In other words, has the rally gotten ahead of itself? We have noted that we have had an above average rebound from the bear market trough, but the bear market ending March 9, 2009 was itself much worse than average and had taken stock prices to unprecedented lows. Further, cumulative global stock returns since the previous peak in October 2007 remain negative, suggesting the potential exists to extend the current bull rebound. Annualized index returns for a U.S. Dollar investor for November 1, 2007 to December 31, 2010 are as follows:
The outlook for U.S. interest rates, a fourth issue, is at once both clear-cut and murky: clear-cut because rates have been historically low, and have but one direction to go, which is up; murky because the timing and magnitude of rate increases along the rate curve is not knowable. As we reported in last quarter's client letter dated October 21, 2010, "…two deep bear markets this decade have represented a textbook example of reversion to the mean for U.S. stock returns in this decade versus the previous. Likewise, some market watchers are raising a related alarm regarding bonds, warning of a reversion to the mean for their returns after almost three decades of returns that have been well above historical averages. If such a reversion occurs, it will be because interest rates have finally bottomed, meaning future rate increases will cause capital losses on bonds, producing lower or even negative total returns." This risk of loss presents a serious challenge to portfolio allocation strategy. Bonds have been a traditional hedge against the inherent volatility of stocks and have almost always smoothed overall portfolio results. To dramatically reduce the bond allocation is to court excessive riskiness. Another strategy to respond to the risk of loss would be to substantially shorten the maturity (also known more technically as duration) of the portfolio's bond positions. The opportunity cost of this strategy is very high currently: the yield curve is steep, meaning longer term bonds are paying much higher interest rates than short term. If an investor loads up on short-term bonds, the yield loss will be 3-5 percentage points, a very high opportunity cost if the investor is wrong because longer-term interest rates do not increase during 2011. The outlook for the direction of the U.S. dollar is not particularly murky. It must continue to depreciate for two reasons. First, there is the on-going increase in investors' risk appetite, which weakens the dollar. Second, huge deficit spending to stimulate our economy is combining with on-going trade deficits to flood the world with U.S. dollars. This large incremental supply of dollars requires a cheapening of the dollar to entice adequate incremental demand by buyers. Again, the usual caveat of no guarantee. Overseas, it is very difficult to predict the policies of various central banks, including the UK, EU, and Chinese authorities. Finally, it is still possible we could experience the "mother of all credit crunches," wherein foreign buyers demand much higher interest rates to buy and hold our debt. Thus, we note the interrelated nature of these issues and the considerable difficulty in making projections involving both the dollar and interest rates. 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? As we have said before, we believe the future is unknowable, so we are again going to refrain from making a point-by-point 2011 projection. We believe the current consensus intermediate-term forecast for stocks is bullish and for bonds is bearish. We agree regarding stocks, but we are less pessimistic than the consensus regarding bonds. Nonetheless, these are only guesses. Accordingly, we are planning to avoid any major tactical underweighting or overweighting. We will position client portfolios in 2011 predicated upon 1) the need for bonds to hedge against stock volatility, and 2) careful selection of bond sectors and duration to manage risk and take advantage of remaining opportunities in fixed income globally. 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, poor policy implementation, and a host of other factors could wreak havoc with these predictions, and there is always the risk of the totally unexpected. Therefore, results in 2011 could be considerably better or worse, or at least different, than indicated above. Risks to Forecast, Especially Beyond 2011We consider longer-term risks to far outweigh short-term risks because expansionist policies, especially in the U.S., are "kicking the can down the road." As indicated by Bill Gross (see the Blog Department), we are putting off seriously addressing our socioeconomic problems, particularly excessive debt, and there will eventually be hell to pay. We do expect the economic recovery to continue in 2012. The main risk to the forecast of continuing economic growth is that the U.S. economy will not respond strongly to monetary and fiscal stimulus. Pessimists say the stimulus is in vain and like "pushing on a string." They note job growth data continues to be quite discouraging, and consumer confidence remains pretty much flat. If the economy does not respond, GDP growth will underperform expectations, consumers will retrench, and corporate profitability will suffer. Finally, it is noteworthy that corporate profits face much tougher prior year comparisons in 2011 than in 2010 and could disappoint. Another risk to the sanguine outlook for stocks is the challenges facing emerging economies. Can they maintain their growth in the face of increasing domestic inflation, environmental challenges, and trading partners demanding fairer currency policies (for example, upward revaluation of the Chinese yuan)? On the flipside, the U.S. economy may overheat and sooner than presumed by our outlook. In fact, many economists expect overheating to occur inevitably (as usual, the timing is hard to pinpoint). If there is overheating, inflation will increase, sending up interest rates, which normally has far-reaching negative consequences not just for bondholders but also consumers and businesses and therefore stock prices. The expected decline of the U.S. dollar is subject to numerous macroeconomic and geopolitical risks, especially respecting currencies of other developed countries. The expected relative strength of the U.S. economy versus lagging ones in U.K. and Euroland will tend to support the Greenback versus the Pound and Euro. Also, any event which decreases investors' risk appetite, whether further debt crises in peripheral Europe (Spain?) or of a major geopolitical nature (Iran, Pakistan, Korea?), causes a flight to the safety of U.S. Treasuries and therefore the dollar, raising its exchange rate. As very evident since bursting of the Internet bubble to start this century, investor psychology continues to play an important role and amplify unpredictability. In 2008, seemingly overnight, fear and retrenchment replaced complacency and greed, and we witnessed a massive downward repricing of essentially all risky assets in response to housing and credit crises both in the U.S. and abroad. Investor psychology not infrequently seems to turn on a dime and gain momentum quickly, and it did so in March of 2009. With bonds and at least some stocks priced for a global Depression, it did not take much encouraging news to begin a rebound. Moving to the present, investor psychology appears to have jumped very positively toward the end of 2010 in response to additional U.S. government economic stimulus (QE II and the 2010 Tax Relief Act). Though investors have a reputation of having short memories, it is unlikely they have forgotten the pain of 2008 (and even 2000-2002 earlier), so we should expect continued "jumpiness" by investors. Looking beyond 2011, in many respects we have the same concerns, implied above, expressed in previous years, and trumpeted by Bill Gross. They stem from the belief that the tax-cut and deficit spree of the Bush administration, now followed by the Obama administration continuing the same basic fiscal policy and adding further to deficits and the Federal debt, have juiced up the economy but will exact a price in later stagnation. 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. Implications for Asset AllocationBecause 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. Therefore, we are avoiding anything resembling a significant departure from client policy allocations. With the consensus seeming to be bullish on stocks but bearish on bonds, it is tempting to substantially overweight stocks. Nonetheless, we believe it is prudent to remain conservative in the face of challenging and uncertain economic, market, and geopolitical conditions. Therefore, we are resisting this temptation, we are continuing our emphasis on capital preservation, and we are keeping tactical adjustments to a minimum. Relevance of Market Review and Outlook for the Strategic AllocatorBefore concluding, let's address the relevance of a review and outlook and clarify why we are minimizing tactical adjustments, as follows:
Outlook Scorecard, Strategies Employed, and Impact on ResultsLast year was the twelfth time we attempted something resembling an outlook. A scorecard is in order to see if we are gaining anything from the effort. Our report cards until 2008 were generally favorable: we had more predictions right than wrong, and our errors have not been harmful to returns. Unfortunately, we cannot say the same for our 2008 and 2009 outlooks and investment tactics. To be fair, both years were unprecedented and produced investment results which were exact opposites. Respecting last year's 2010 Outlook, our assessment of the global economy was accurate, but we were less optimistic than the consensus about equities, especially U.S. equities, and were surprised by their strength in the second half of 2010. Last year's outlook indicated "stocks are modestly to moderately overvalued at present and will be slightly underweighted, accordingly." As indicated in the accompanying letter, an occasional negative report card is inevitable for a firm such as Caves & Associates, which generally follows a non-timing, strategic allocation approach. To conclude respecting allocation strategy, the 2010 outlook did not contain any detailed asset class tactical forecasts, so we cannot provide a point-by-point report card. Please refer to the accompanying letter for its comments about last year's outlook and the performance of our 2010 strategies. Respecting a scorecard for the mutual funds we employ in client portfolios, they remained highly rated by and large. As evidence, one of "our" mutual funds was among the 15 recently nominated for Morningstar's 2010 managers of the year (Morningstar is highly regarded for its mutual fund databases and mutual fund ratings). Historically, nominees and award winners have been 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. The undue conservatism of our 2010 Outlook in hindsight becomes a moot point in the sense that an accurate, very positive outlook would not have dramatically changed the returns of portfolios supervised by Caves & Associates. That's because of the Caves & Associates philosophy of staying the course. Even though we underestimated future stock market strength in 2010, pursuing this philosophy meant clients did not miss significant gains as a result of being out of the market (or substantially underweight) because we generally "ignored" our 2010 outlook and maintained substantial stock exposure last 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 fear and the temptation to exit stocks, but we must hold the course, thereby "assuring" we will 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. However, markets move upward as rapidly as they move down, and it is very easy to linger too long in the perceived safety of a decreased exposure to stocks, thereby incurring an opportunity cost by missing the benefit of the ensuing bull market run-up. |
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