Quarterly Investment Commentary

 

First Quarter 2013 Key Takeaways

• U.S stocks posted gains above developed and emerging interna- tional markets.

• Our slight underweight to equities and tilt towards international and emerging markets resulted in a headwind during the quarter.

• Our active bond managers added value vs. Barclays’s Aggregate Bond Index as well as our floating rate position.

• The U.S. economy is improving slowly thanks to accommodative Federal Reserve policy.

• Significant uncertainty remains both in terms of fiscal policy and monetary policy in most developed markets.

• We view U.S. equities as being fairly valued currently but subject to a pullback.

• We continue to view Emerging markets favorably.

• We continue to favor our flexible, active bond managers.

“We strive to protect and grow our clients’ capital over the long term by: (1) focusing on individual client goals & objectives; (2) having proper as- set allocation to fit a client’s volatility/risk tolerance); (3) stress testing short term liquidity needs; (4) investing with value orientation – picking managers who understand the intrinsic value of a business and margin of safety.” -Our Goal

First Quarter 2013 Investment Commentary

U.S. stocks moved sharply higher in the first quarter, with both the Dow Jones industrial average and the S&P 500 hitting new all-time highs (in nominal terms). The S&P 500 gained approximately 11% for the quarter, while smaller-cap stocks shot up by 12%. Despite worrisome developments in the Eurozone, developed international stocks gained roughly 4% and emerging market equities were down about 4%.

The yield on core investment-grade bonds rose slightly in the first two months of the quarter, with the 10-year Treasury yield moving from 1.8% at year-end to over 2%, before ending the quarter roughly where it started (the 10-year yield last touched 2% in April 2012.). So in terms of total return, both Treasuries and the Barclay’s Aggregate Bond Index ended flat for the quarter, along with municipal bonds.

The US economic fundamentals continue to improve – very slowly however. Unemployment is gradually falling, home prices have been rising, and corporate earnings and profitability are near record highs. Fed actions have also continued to support—and drive—strong U.S. stock market gains. However, looking ahead, significant uncertainty continues for our fiscal and monetary policy in terms of what policies will be adopted and their ultimate economic and financial market impacts. More broadly, still high global debt levels pose an economic headwind.

The rise in US stock prices has reduced expected future returns. We continue to monitor the valuation level of the general US market and continued appreciation could result in a reduction of the US stock allocation. We continue to find emerging market stocks attractively priced relative to US stocks and have a meaningful allocation to them for all client portfolios.

For the fixed income portion of portfolios, most of the bond market offers paltry longer term return potential. Al- though needed for portfolio “ballast”, diversification and income generation, we believe that our active, flexible fixed income managers will provide better returns than “core” bonds over the long term (5 years).

What Now for U.S. Stocks?

With U.S. stocks hitting new highs, we are naturally get- ting two questions from clients:

1) With stocks up so much, shouldn’t we reduce our expo- sure (to lock in gains, given all of the big picture risks)?

2) With stocks up so much, shouldn’t we increase our exposure (since the economy must be much better than people expected)?

Our short answer to both questions right now is, no. Over- all our outlook for stocks has not improved, and, if any- thing, given the sharp run-up in stock prices, the implication is for lower future returns over the five-year investment horizon. Unlike market timers, we offer no advice on short-term equity market direction other than we expect volatility. That said, despite the strong rally, we continue to believe that equity valuations are still reasonable, trading at 14x 2013 forecast earnings while long-term bonds are substantially overvalued.

We believe there is an unusually wide range of possible outcomes for economic fundamentals and hence the market. This includes some positive scenarios for U.S. stocks (with annualized returns in the low double digits), as well as some severely negative outcomes as the U.S. and the entire global economy works through the aftermath of the financial/debt crisis of 2008. While we believe the weight of the evidence tilts more toward the left side (the worse side) of the distribution of possible outcomes, the reality is that we do not have a high level of conviction in any one particular scenario playing out.

To some extent, we are hedging our bets—also known as diversifying—and that is the prudent thing to do in an environment this uncertain. We are constructing “all weather” portfolios that we believe should perform reasonably well across a range of potential outcomes, any one of which we believe has reasonable odds of actually playing out. But if one of the more extremely negative or positive scenarios unfolds, our portfolios are not going to do as well (at least over the shorter term) as a portfolio that has made a big bet on that particular outcome. Of course, if a particular extreme scenario doesn’t happen, then those extremely positioned portfolios would experience commensurately poor performance. We don’t think making a big bet on an outcome that can’t be determined with confidence is in the best interests of our clients.

The Environment: Policy Uncertainty and Modestly Improving Economic Fundamentals

A major contributor to the uncertainty we face in today’s environment surrounds government policy, both fiscal and monetary, specifically what policies will be adopted as well as their ultimate economic and financial market impacts. With respect to fiscal policy, in the first quarter the markets digested the sequester’s spending  cuts without much drama. But the sequester’s impact (estimated at around a 0.6% hit to GDP growth in 2013) is small potatoes compared to the debt and fiscal policy challenges that still confront the nation. Although we would agree that there is not an immediate federal budget deficit crisis, and that there is a real risk of snuffing out what remains a weak economic recovery with too much near-term fiscal austerity, there is clearly a debt/deficit crisis, at least in the medium to longer term, given the mismatch between federal revenue and spending. This calls for a strong and credible longer-term fiscal policy response, and the sooner the better. We won’t hold our breath, but maybe our political leaders in Washington are starting to get the message. If so, that could be a major positive catalyst for both the financial markets and the real economy. On the  other hand, it may yet take a crisis to create the political will necessary to implement meaningful structural fiscal changes.

On the monetary policy side, there is more clarity at least in terms of the policies already in place. The leadership of the Federal Reserve (Chairman Ben Bernanke and Vice Chair Janet Yellen, among others) continue to be very vo- cal in stating that the Fed is not close to starting to unwind their stimulative policies, which involve purchasing $85 billion per month of Treasury bonds and mortgage-backed securities (quantitative easing) and holding the federal funds policy rate near zero percent. But there is significant uncertainty as to the medium- to longer-term ramifications and unintended consequences of these policies  and whether or not the Fed’s ultimate exit plan will be executed successfully and without collateral damage. Based on the Fed’s historical record of policy overshooting—and just the inherent complexity of the task at hand for anyone to get it right without a lot of luck—most, including us, are skeptical.

In the meantime, Fed statements and actions continue to be an important support and driver of short-term stock market performance. While central bank actions have al- ways influenced the stock market, the markets appear particularly attuned to and reliant on ongoing highly accommodative Fed policy. Again, over the near term, we don’t see any catalyst for Fed policy to become restrictive. So that leg of support to the markets is likely to remain in place. But the uncertainty increases as the time horizon extends, and our confidence in our ability to be “ahead of the market” in assessing a change in Fed policy and repo- sitioning our portfolios accordingly is very low.

Supported by accommodative monetary policy, U.S. economic fundamentals have continued to grudgingly im- prove. The unemployment rate continues to slowly fall, although that’s partly driven by a particularly sharp drop in the labor force participation rate, meaning there are fewer people working or seeking work, which is not a good thing. The housing market is strengthening, although mortgage lending to households remains tight, and house- hold wealth is growing, driven by stock market and housing price gains—a key goal of the Fed’s QE program. Finally, corporate earnings and profitability are around their all-time highs. (That said, S&P 500 earnings growth in 2012 was actually slightly negative for the year; the market’s 16% return in 2012 came from stock valuations get- ting richer, not profit growth.) But our concerns about the impact of global debt-deleveraging on economic growth and corporate profits remain.

Outlook for Stocks

Based on the wide range of potential returns across different economic and financial scenarios along with our port- folio construction goals of limiting twelve month down- side thresholds, we continue to have a slight underweight to stocks in most client accounts (a little more  under- weighting to our most conservative portfolios). The under- weight is in our international and emerging market positions as we are at our neutral allocation level for US equi- ties. We believe stocks perform at least reasonably well across a meaningful portion of the potential return range, both in absolute terms and relative to other competing as- set classes/strategies in which we could invest.

We continue to see more attractive absolute and relative returns in the emerging markets. Emerging-markets stocks underperformed U.S. stocks significantly in the first quarter. This led to an increase in the future return potential for emerging-markets stocks versus U.S. stocks and it is possible that we may increase our allocations at some point, especially if US stocks continue northward. We are mindful that emerging market stocks would have worse short- term downside risk relative to US stocks in a severe recession scenario.

Update on Bond Markets and Fixed-Income Positioning

The big-picture bottom-line is that the fixed-income marketplace (“return free risk”), particularly the highest quality parts, continues to offer paltry longer-term returns given our expectation for rising interest rates over the five- year investment horizon. Most areas of fixed-income are trading at historically elevated prices, and yield levels are at or near historic lows.

What this means in terms of our fixed-income positioning is that our balanced portfolios remain heavily underweight to core investment-grade bonds, at slightly under half of our strategic target weighting. In their place we have large allocations to flexible and absolute-return-oriented bond (and bond like) managers that we expect to outperform the core bond index across the five-year investment horizon. We are also researching alternative managers who operate in a mutual fund framework whose goal would be to provide diversification and returns in excess of a traditional mix of stocks and bonds but with reduced volatility.

A Word About New Tax Rates and Compounding

Beginning in 2013, we have even higher taxes on virtually all income, including investment income (rents, interest, dividends, capital gains, etc.) Thus, it is even more important to consider the tax impacts of investment decisions. As CPA’s as well as investment advisors, we are constantly aware of this; however, we are careful not to let the tax deci- sion override smart investment decisions.