Economic Notes & 2013 Portfolio Strategy – December 31, 2012
The last week of the year is traditionally one of the lightest, so we’re featuring an abbreviated economic report this week.
(+) New home sales gained +4.4% for November to 377k units, which beat analyst predictions of +3.3% growth. Over the year, this metric is up +15%, which is in line with other positive housing metrics.
(+) Pending home sales jumped +1.7% for November month-over-month, which beat the estimate of +1.0%. The Northeast and West regions were responsible for the majority of the gains, while the South and Midwest ended up with flat results. These figures are right in line with a trend of positive housing data.
(+) The Case-Shiller home price index for October rose +0.7%, which bested the forecasted +0.5% gain and moved to a +4.3% gain year-over-year (the index has risen almost every month this year). This index keeps beating expectations—led by over +1% showings in Las Vegas, San Diego and Atlanta during the month, while Chicago and Boston posted slight declines. The only negative is that it’s old news—over a month old by the time we see the results.
(-) Consumer confidence for December dropped to 65.1, which was quite a bit lower than the expected 70.0 figure. The Conference Board sponsor blamed the fiscal cliff as the primary source for respondent pessimism this month, noted in the poor ‘future expectations’ reading. The present situation, however, did improve for the fifth straight month. The labor piece, which measures how plentiful jobs appear to be, was better but still extremely negative relative to history.
(-) The Richmond Fed Index came out with a +5 reading, which was weaker than the +8 expected and the +9 November figure. The composition was mixed, with shipments and new orders coming in lower, as was the employment segment. In line with other surveys, respondents seemed gloomier about future prospects, which may connected to fiscal cliff concerns.
(+) By contrast, the Chicago PMI came in at 51.6—better than the 51.0 expected by consensus. Future new orders were much stronger than in November, but the employment index component declined soundly. Production and other components were mixed, although fiscal cliff concerns certainly weighed on sentiment.
(0) On the employment side, initial jobless claims for the Dec. 22 ending week fell to 350k, which was lower than the expected 360k figure. Continuing claims for the Dec. 15 week were reported as 3,206k—right as expected. This would normally be a positive, but the DOL had to estimate results from 19 states due to holiday closures, so this release is less reliable than normal.
Now, the fiscal cliff. We’re not going to attempt a rehash of the incredible amount of news coverage on the topic from the last few weeks, but can put an investment perspective on things. We have been inundated with opinions, discussions and assumed outcomes from various mutual fund firms, economists and political strategists over recent months. Some of this content is worthwhile, but much is redundant and offers little new insight. The consensus opinion from firms we feel provide better depth of thought is that the extreme negative outcomes from the cliff are likely to be avoided. (This is not to mention that the overall effects are gradual in nature, as opposed to a ‘switch’ being flipped with all going to hell in a handbasket on Jan. 1). Instead, it seems likely that some type of negotiated compromise will be reached…if not by New Year’s Eve, then certainly by early in 2013. The benefit of a 2013 agreement is the politically more tenable outcome that allows many Republicans to maintain a pledge of not ‘raising taxes’ (for more information, google the name ‘Grover Norquist’). How does this work? If the Bush tax cuts are allowed to expire and rates rise by mandate on Jan. 1 to the previous level, any agreed-upon compromise would likely result in a ‘tax cut’ of some sort. Convoluted, but not unheard of in Washington.
The debt ceiling (again) is another upcoming deadline in January. This brings flashbacks of 2011, and the political gridlock that led to an S&P downgrade of U.S. debt based on a lack of conviction in solving the problem. This may prove to be more disconcerting to markets than the ongoing fiscal cliff concerns of late.
Year-End Notes (Special Feature)
Now that we’re at the end of the year, we wanted to take a few moments and provide an update on where we stand from an asset class standpoint at year-end as well as how we’re positioned moving into 2013.
In 2012, we were faced with similar pitfalls as the preceding years: continued headwinds of slow economic growth in both the U.S. and abroad, a contentious presidential election featuring candidates with very different views on America’s future in keeping with a polarized electorate, an upcoming ‘fiscal cliff’ of budgetary tightening absent congressional action, continuing European sovereign debt woes, as well as more subtle risks of slower growth momentum in several key emerging market nations such as China and Brazil. On the positive side, growth remains positive (even if it isn’t at the level we’d like to see), and economies are operating with plenty of ‘slack,’ meaning that there isn’t the excess present that usually precedes bubbles and recessions. Pessimism is also high, which can be a positive for investment returns.
From an investment perspective, general portfolio themes can change with conditions in the shorter-term or can remain valid for a long period of time. However, in any asset class we evaluate, our view of the attractiveness of an investment is based on its current valuation, which is very much related to its prospects for future returns. The following provides a summary of how various asset classes where we have exposure fared during the past year, and how we are positioned going forward.
Bonds – Government
Fixed income investors generally look for several attributes: income from bond coupons and some degree of price stability. As professional investors, we would also add that portfolio diversification is a critical component. Over time, U.S. government bonds, including both Treasury and mortgage-backed agency debt, have served as a conservative cornerstone in the portfolios of many different types of investors and have historically provided a better yield than that offered by certificates of deposit or savings accounts (generally a percent or two of ‘real’ yield—yield above the going rate of inflation). However, times have changed.
During the last few years, the Federal Reserve has used the government bond market as a tool to kick-start the economy—the theory being that low interest rates may stimulate growth, or at least reduce potential headwinds for consumers and businesses caused by higher rates. This has left conservative bond investors with few choices and low yields (including negative below-inflation real yields). Our positioning here has been to minimize the damage, so to speak, by underweighting the asset class and investing in areas of government debt that offer positive opportunities. These include utilizing a unique niche strategy in seasoned high-coupon agency mortgages, and an allocation to municipal bonds in taxable accounts—an area that has been subject to some extreme headlines in recent years, the reality of which has been much more tempered. At the same time, careful bond selection has been critical, which is why we feel a strong management and research team is important.
Bonds – Corporate
To offset the underweight to government debt, we have overweighted corporate bonds, due to more attractive (cheaper) valuations and what we believe to be more compelling prospects looking forward should interest rates rise. In fact, during the year, corporate bonds were one of the primary drivers of ‘value-added’ in our portfolios, as holdings taken as a total group provided roughly two times the return of the Barclays Capital U.S. Aggregate Bond index.
Some of the holdings in the group performed so well that we decided our chances for continued upward momentum were less likely. In the case of convertible bonds, we decided to take our gains and reallocate the proceeds into existing holdings of investment-grade and high yield debt. From the initial period we invested in convertibles in October 2008 until the final sale of our position in February 2012, the group provided a significant cumulative total return. This was a success indeed, based on a purchase made during a time when no one wanted these bonds—characteristic of our discipline and time horizon.
As corporate bonds can have risks, we diversify the portfolio according to several themes. These include more conventional intermediate-term bonds issued by a variety of corporations, screened for fundamental quality and valuation—such bonds have provided better income and price appreciation than government debt relative to the risks taken. Secondly, we have used below-investment grade (aka ‘high yield’) bonds strategically over the past several years when we feel potential rewards outweigh the risks. Now, with corporate balance sheets in better condition than they have been in decades, we feel the potential for good returns remains present (this has been one of the best-performing themes in the portfolio since the 2008 financial crisis).
Lastly, we remain watchful of interest rates and the potential negative impact that sharply rising rates can have on bond prices (whether rates rise as a result of the negative impacts of inflation or as a byproduct of an improved economy). For that reason, we hold an allocation to ‘floating rate’ securitized and publicly-traded bank loans. Unlike conventional bond prices, which move in the opposite direction of rates, these investments ‘float’ along in the same direction as rates, giving us a bit of a hedge against conditions that may be harmful to other bonds. Additionally, we are paid to wait with an attractive yield. Aside from use of floating rate instruments, we also keep our overall bond portfolio maturity relatively ‘short’ to minimize potential interest rate impacts, which we see as a greater risk than continued falling rates.
Bonds – Foreign
During the year, our foreign bond holdings provided strong performance versus the broader foreign bond market. Mid-year, we made a several small portfolio adjustments to realign exposures between the impacts of currency, maturity/duration and credit. That re-positioning bore fruit this year, as results originated from a variety of these exposures, including emerging market debt and currencies.
For several years, we have operated under the theme that emerging markets have become more liquid and efficient, offer more attractive yields, as well as feature economic and fiscal fundamentals that rival (and, in many cases, surpass) traditional developed market economies as in Western Europe and Japan. While investors generally disregarded this trend during 2011’s ‘flight to safety’ by flooding to bonds of already-indebted nations, the emerging market theme resurfaced positively in 2012. While keeping a normal weighting to foreign bonds overall, we continue to feel these emerging areas hold promise looking forward and continue to de-emphasize heavily-indebted developed economies.
Stocks – US Large Company
Despite news-driven concerns throughout the year, large American blue chip companies performed strongly relative to historical averages (well over their long-term 9-10% average annual result) as well as smaller-cap stocks. Our portfolios have retained an overweight to large-cap, relative to other equity categories, due to more compelling valuations at the larger-end of the stock size spectrum and the variety of attractive characteristics offered by such firms, such as diversified product lineups, wide global reach, and the highest-quality balance sheets in several decades.
In the middle of the year, we began a consolidation of positions in large-cap, removing a separate sector weight to technology and further diversifying our positions into other sectors—while retaining a ‘tilt’ towards growth industries (such as consumer stocks, healthcare and technology) rather than more cyclical value sectors that appeared more expensive at the time. At the same time, in keeping with our investment philosophy, we continue to align holdings towards areas we feel hold the most promise relative to the broader market. These weightings continue to be focused on growth industries, which appear to offer us the best combination of earnings growth and attractive valuations.
Stocks – US Mid/Small Company
We have utilized mid-cap stocks in the portfolio for a number of reasons during the past decade, not the least of which being that this part of the market occupies a ‘sweet spot’—companies that offer better financial stability than smaller-cap names, coupled with more flexibility and growth potential than many large-cap companies. Valuations here have also been compelling (almost but not quite as attractive as large-cap companies), while smaller-cap firms have tended to look more expensive in recent years relative to their history.
As we begin a new year, our positioning remains towards ‘growth at a reasonable price’, which couples a focus on underlying fundamental quality with sustainable growth prospects and a reasonable valuation paid for that growth. Performance in Mid/Small cap stock lagged the broader mid-cap index by a bit during the year, which is not surprising—quality firms can sometimes underperform during shorter-term rising markets. We currently hold a slight overweight to mid-cap stocks and an underweight to small-cap.
Stocks – Foreign
Foreign equity markets have experienced high levels of uncertainty and resulting volatility in recent years—stemming from European sovereign debt issues, lack of growth in Japan and concerns about unrealized high expectations in emerging markets. Despite these crosscurrents, foreign equities performed decently and better than U.S. equities in many cases. Our positioning shifted a bit earlier in the year, from more opportunistic allocations and focused allocations in certain regions and sectors, to more diversified exposures across sectors and countries.
A theme that has remained consistent, however, is a significant ‘tilt’ toward emerging market regions, such as the Far East and Latin America. We not only expressed this idea through direct investment in these stock markets, but also through more indirect ‘growth’ exposure in firms domiciled elsewhere (including Europe) yet earning a significant portion of revenues in these faster-growing nations. It is our view that such firms could be underappreciated due to ‘macro’ European headlines and may offer compelling rebound potential looking ahead. We continue to hold a ‘normal’ weight to foreign stocks presently.
Alternative Investment Assets:
We continue to believe real estate investment trusts are an important diversifying element in our portfolios, even if this type of real estate is sometimes confused with the more newsworthy residential variety. Their characteristics, however, are quite different. The REIT market has traditionally included Class A office buildings in major American and global urban centers, but more recently encompass healthcare facilities, apartment buildings and self-storage complexes—each with their own economic dynamics. REITs are generally valued based on a metric called market price-to-net asset value, which is a ‘Wall Street’ versus ‘Main Street’ evaluation of these separate properties in their own right.
In recent years, we have underweighted the real estate asset class overall due to what we believed to be more compelling opportunities elsewhere in the equity markets. However, early in 2012, we began to rebuild our weighting to REITs as a result of more normalized valuations and desire for additional portfolio diversification in a slower growth environment. U.S. REITs as a whole have been a bit more expensive than REITs abroad, so our overall asset allocation has been tilted towards a ‘global’ focus—a bit more toward non-U.S. than U.S.
Commodities / Managed Futures
Commodity markets come with a set of interesting characteristics. While serving as one of the more effective diversifying pieces of a multi-asset portfolio, due to long-term low correlation to other assets, certain markets offer attractive long-term returns in return for volatility on an individual level.
To make the evaluation even more complicated, the group can be divided into several distinct segments: economically-sensitive (including energy commodities like oil, and industrial metals like copper); geopolitical risk-sensitive (precious metals like gold and silver, as well as crude oil to a certain extent when certain regions of the globe face uncertainty); and ‘other’ (which includes the less-predictable and often weather-dependent components like wheat and corn). While commodity indexes constructed based on world trade volumes place overwhelmingly heavy weightings towards energy contracts, we have elected to diversify further towards non-energy commodities including metals and grains. Additionally, careful management of underlying collateral (the cash not used directly for futures contracts) in a variety of fixed income areas has boosted returns and helped us perform well in 2012 despite a generally flat commodity market.
Other Asset Classes
We continue to believe in and have exposure to additional investment opportunities (hedge funds, global eclectic, long/short and others) that remain outside the traditional stock, bond and cash assets. Numerous studies have shown one of the main benefits of the addition of alternative assets is to provide a more consistent / lower volitality portfolio. We have had exposure to these various asset classes for a number of years, but since 2007-2008 we have consistently maintained a higher exposure due to what we see as the very logical arguments made by individuals like Reinhart & Rogoff (READ: Journal of Economic Perspectives)
A crystal ball is hard to come by in the investment world. There is no magic formula for outperforming the market consistently and/or without taking on commensurate risks. Our valuation-oriented approach seeks to take advantage of longer-term asset class dislocations and the tendency of investment returns to ‘regress to the mean’—as in, more expensive assets becoming cheaper, or cheaper assets improving in price back to fair value. As history has taught us, an opportunity to add value exists on both sides of this equation.
In 2012, we made several moderate adjustments intended to better balance overall risk exposures in the portfolios. The result was not one overwhelming theme, but a series of smaller improvements that were noted in the final results for the year—improved returns earned with lower volatility than we would have experienced without making the changes.
As we look ahead to 2013, economic growth in the U.S. and globally remains slow and unemployment domestically remains high. In response, the Fed has kept its monetary policy accommodative and, more recently, targeted to specific unemployment rate and inflation thresholds. One underreported story is the level of exposure of U.S. firms to faster-growing emerging markets, which may provide a boost in growth beyond what might be expected from our own economy. Another positive is reasonable valuations in equities that could benefit investors taking a bit of risk as opposed to overweighting ‘safety’ (bonds and cash), some areas of which appear to be somewhat expensive at this time. In this mixed environment, we remain quite encouraged by our positioning from a bottom-up asset class-by-asset class standpoint.
|U.S. Treasury Yields||
Domestically, stocks were weak on the short Holiday week—mostly due to poor headlines regarding the fiscal cliff negotiations in Washington.
In the S&P, Materials and Financial stocks outperformed with the smallest losses, while energy and utilities underperformed on the week. Large-caps and small-caps were largely similar, while foreign stocks ended up stronger than domestics.
The EAFE was flat on the week, although the Japanese component gained ground at the expense of European stocks. Generally, the new regime in Japan has been received positively, which has resulted in Japanese stock gains in recent weeks—the premise being that added promised stimulus should result in better economic/profit growth. It has also caused the Yen to drop significantly, due to fears of potential inflation and views of the currency as somewhat overvalued currently.
Treasury bonds performed well, inversely to equities in a risk-off week. Long bonds gained the most ground, and credit was up slightly. Foreign bonds were down slightly in the slow week.
Real estate was down in keeping with equities, with foreign REITs outgaining domestic issues. Commodity markets were mixed on the week. Energy was up roughly 1.5% with higher oil prices, and was the best-performing sector, while agricultural contracts lost a percent, as the worst performer.
Have a good week – and we wish all of you a happy, healthy and prosperous New Year!