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Are We There Yet?

by Victor K. Lai, CFA


2012 is 20/20


Looking back with 20/20 hindsight, we can say that 2012 was a good year for the markets. Stocks, bonds, and real estate all managed to deliver positive returns. There were surprises for everyone. Given the widespread turmoil throughout Europe, few people would have expected foreign developed stocks to be one of the best performing markets. Likewise, many were surprised that bonds remained in positive territory despite strong stock market performance. Many analysts expected the 10 year Treasury yield to end the year above 2%, instead they stubbornly held onto a 1% handle. We had a few surprises ourselves, some of our opinions were simply incorrect, and like other investors, we had to take the good with the bad.


For example, we were bearish on US stocks, and we ended up being just plain wrong. Though US stocks had a rough first half, they ended the year with strong double digit returns. Likewise, our preference for cash was not productive either. On the other hand, we also had some opinions that worked out well. For example, our bullish opinion on foreign developed stocks, bullish opinion on real estate, and our bearish opinion commodities all worked in our favor. As we pointed out above, foreign developed stocks in particular did very well and ended up being one of the strongest performing markets in 2012 (represented by the EAFE index). Figure 1 shows the monthly price performance for major asset class indices in 2012. Note that commodities were the only asset class that lost value.


Figure 1

Source: Yahoo Finance, BCM

Are We There Yet?


Hindsight may be 20/20, but those forward looking crystal balls, on the other hand, tend to be both foggy and blurry. As we did going into 2012, we continue to have concerns (more on that later). Of course, everyone (including us) would like to know exactly when those concerns will escalate to problems in the market. The longer we wait, the more we start sounding like children in the back seat chanting “are we there yet?” Unfortunately, this is unlike a trip to the amusement park, and due to the opacity of our crystal ball, we really do not know how long it is going to take. All we do know is that is that markets can be irrational and impossible to time.


We realize that “we don’t know” is not inspiring. However, investing is a game of chances. It involves inherent uncertainty and there are no “100% guarantees.” For many investors, the sad truth is that the odds of winning the game (being right) are no better than a coin toss, and often worse! Even among professional investors, doing better than that can be challenging. With that in mind, it should be inspiring to know that we do not need to be right 100% of the time to be successful. In fact, slightly favorable odds can be enough. We explain this in greater detail below.


Better Than a Coin Toss


Imagine a game in which we continually make bets of consistent size, say $100. Let us assume that we gain $100 when we are right, and lose $100 when we are wrong. Let us also assume that we are able to win (be right) 60% of the time. Winning odds of 60% are not fantastic. Furthermore, 60% odds do not mean that we will win 6 out of every 10 bets. In fact, given these odds, it would not be surprising to see periods when we only win 1 (or even 0) out of 10 bets. However, over the course of many, many bets, we would expect to see an overall winning percentage of around 60%. The greater the number of bets, the more likely this is to be true. All else equal, that also means we would have an expected overall gain. In this example, the expected gain for each bet would be $20, a return of 20%. In probability terms, (0.60) x ($100) + (0.40) x (-$100) = $20.


While 60% would not make the academic honor roll, this example shows that even a “D-” can make the cut when it comes to investing. For long term investors, the reality is that even slightly favorable odds can actually be enough to win at the investing game. Furthermore, there are a few simple, practical steps we can take to tilt the odds in our favor.


1. Maintain a Long Term Perspective

We are playing for the long run. Do not be deterred by short term outcomes because the long term results are the ones that matter.


2. Maintain Market Exposure

There are no guarantees, and there will be losses. Regardless, we must continue playing because we cannot win if we are not in the game.


3. Maintain Risk Management

Risk management is crucial. Keep your bets within sustainable limits to prevent being forced out of the game prematurely, due to a single or series of losses.


These simple points are built around the fact that time can be a natural advantage. The longer we stay invested, the more likely we are to be winners (make money). From a historical perspective, the time advantage is very compelling. For example, consider the historical probabilities of incurring a loss in the S&P 500 based on different holding periods from 1925 to 2012. Based on randomly selected one year holding periods, the S&P 500 would have incurred losses 25% of the time. Based on five years, the percentage of losing periods falls to 14%. At ten years, the percentage of losing periods is only 3%. Figure 2 shows a summary.


Figure 2

Source: Standard and Poor's, BCM

Not surprisingly, shorter holding periods result in higher chances of loss. Based on single day holding periods, the odds of making money have historically been no better than 50/50, literally like a coin toss! This is not to say that extending our holding period to 20 years will guarantee being on the right side of an investment. On the contrary, the possibility of being wrong is always there. Being wrong is part and parcel of the investing process. We are totally aware of this, and it is exactly why we use asset allocation as our primary strategy. For example, though we were bearish on US stocks, we did not eliminate exposure to them. That allowed us to avoid missing the beta-boat in case we were wrong (which we were in this case), to manage risk, and to capture the natural advantage of maintaining exposure over time.


Any tactical positions that we do take (e.g. tactical weighting and such) are always secondary and supplementary to our primary asset allocation strategy. When we do take tactical positions, we do so with the understanding that we may be wrong. Yet, as with our primary strategy, we look for favorable odds. For example, all else equal, the late stage of an expansionary business cycle is likely to have negative implications for risky assets. Likewise, an asset with extraordinarily high valuation is likely to have more downside than upside potential. The point is that everything we do, whether strategic or tactical, involves recognizing imperfect odds and taking the positions that are more likely to be correct. By doing this consistently, we can expect to be marginally more right than wrong over time. It is not perfect, but it is better than a coin toss, and even odds like that can make the investing honor roll.


House of Cards


Having covered the imperfections of our approach, it is time to take another look into our crystal ball for 2013. Regarding the US economic, some year-end data points came in stronger than expected. For example, real GDP growth was revised upward for 3Q 2012 to 3.1%. Employment data has also continued to improve. However, as we explained before, arbitrarily focusing on a single indicator at one point in time can be misleading and it’s important to maintain a broader perspective.


Based on our observations of a broad range of indicators, we believe that we are still muddling through a very weak recovery that could be just as close to contraction as it is to expansion. Worth noting, there seems to be a unanimous consensus among Wall Street analysts that the US is positioned for improved growth in 2013. While we are not calling (and have not called) for the start of a recession, we continue to think that growth will be slower than the street expects.


Our reasoning is straightforward. The problems that created economic turmoil in the first place were never solved. They were simply swept under the proverbial rug. As a result, the US economy is still a fragile house of cards. Figure 3 is an update of a chart we have shown several times. It shows the total assets held by the Federal Reserve (the US central bank, aka the “Fed”). The Fed’s assets expanded by an extraordinary amount in 2009 when it started buying troubled assets (bad debt) from big banks and included them on its balance sheet. While this freed the private sector from some bad debts and provided liquidity, it obviously did not solve the underlying problem (the debt is still there).


Figure 3

Of course the Fed’s asset purchases have included more than just bad debts. The Fed’s “Quantitative Easing” (QE) activities, which purchase Treasuries and other government debts, have also added to the Fed’s asset base. This QE activity, we think, is particularly worrisome, bad for long term economic conditions, and widely misunderstood by the general public. For that reason, we want to digress briefly to clarify what QE is really all about.


Reckless, irresponsible, & generally bad


Despite what some may think, the Federal Reserve is not the body that borrows on behalf of the US government. The Federal Reserve is responsible for controlling monetary policy which includes, among other things, controlling the money supply. It is the US Treasury that borrows for the government. When the US government does not collect enough taxes to fund government operations (which are driven by Congress’s policies), the Treasury borrows money to meet the shortfall. This borrowing is conducted through the sale of US Treasury bills, notes, and bonds (Treasury Securities, or simply “Treasuries”). The government sells Treasury Securities to investors for cash, and in exchange the government promises to repay investors with interest.


To keep borrowing in check, the central bank is prohibited from buying Treasuries directly from the government, a practice known as “monetizing” the debt. The Fed must purchase Treasuries on the secondary market. If not, the government could borrow unlimited amounts of money. It could just sell Treasuries directly to the Federal Reserve, and then have the central bank print money to pay for the debt. Such a relationship would clearly be reckless, irresponsible, and generally bad. So with the central bank out of the picture, the government must sell Treasuries to other investors such as private sector banks, insurance companies, pension funds, other governments, et al. Theoretically, this should keep a lid on government borrowing because at some point investors would own too many Treasuries, refuse to buy more, and cut off the government’s source of funding.


However, that theoretical lid does not stay in place if the Federal Reserve prints money to buy existing Treasuries from private sector banks, and then those banks use the new money to buy newly issued Treasuries from the government. If that were to happen, then the Fed would basically be monetizing the debt, right? But this is supposed to be okay since the Fed is technically not buying directly from the government, just indirectly through intermediaries. Figure 4 shows a diagram of what QE really is, a work around for monetizing government debt.


Figure 4

Source: BCM

Meanwhile, the government insists that QE is a tool for stimulating economic growth and activity. In terms of efficacy for stimulating the economy, QE is like a piece of chewing gum on a leaking dam. It is kicking our can of problems down the road and doing little to actually address the underlying issues. How do we solve a debt problem by creating even more debt? As we have written before, these types of short sighted policies encourage reckless and irresponsible behavior, and also result in highly inefficient resource allocation. Policies like QE may provide policy makers with something to do, but they also do little to create effective and sustainable solutions.


The gift that keeps on taking


Just stop for a minute and think about how much of our resources are taken from productive uses that could create more wealth, and are reallocated to unproductive uses that do not create wealth and create debt instead. The ugly truth is that our tax dollars are hard at work employing the government to create increasingly larger amounts of debt that we the taxpayers must pay for. The amounts are truly shocking. Take a look at Figures 5 and 6, they show the annual amounts of US Federal Deficits and Debt, respectively.


Figure 5


Figure 6

Both deficits and overall debt have risen significantly since 2000, and have literally taken off since 2009. Government spending has produced more than $1,000,000,000,000 ($1 trillion) in deficits per year since 2009. To be clear, that represents additional spending after all tax revenues have been depleted. Total outstanding government debt is more than $16,000,000,000,000 ($16 trillion) as of 2012. At an annual interest rate of 2%, that would be more than $320,000,000,000 ($320 billion) in interest payments per year alone. Just food for thought, while the interest rate on the 10 Year Treasury note is currently below 2%, the long term historical average has been around 6% (which would create $960 billion in annual interest payments).


To add insult to injury, the $16 trillion is a gross understatement of the actual problem. It does not account for the “unfunded liabilities,” or financial obligations already committed to by our government and will need to be funded in the future (think Medicare and Social Security). Given that the government will likely be unable to pay for those obligations with tax revenues, it will need to borrow even more to meet them. Accounting for these unfunded liabilities, the US Congressional Budget Office (CBO) estimates the true total liability to be close to $70 trillion!


These mind boggling numbers are already beyond comprehension, and yet they are unbelievably getting worse by the year. These circumstances clearly affect our outlook on economic conditions. How can we expect things to improve in a meaningful and sustainable way when we are clearly headed down an unsustainable path? We are not talking about short-sighted, one quarter’s worth of surprise GDP growth. We are talking about the type of durable, healthy, long term growth that made the US a global leader. That is the legacy we inherited. In return, we are set to leave behind the single largest debt burden that mankind has ever known. It really will be a wretched gift that keeps on taking, for generations to come.


Fortunately, all hope is not lost. With around $15 trillion of GDP per year, the US is productive enough to eventually climb out of debt. For example, if we paid 10% of GDP towards debt service per year, did not accrue any additional debt, and also grew the economy by enough to at least offset the interest in real terms then we would be debt free in about 47 years. Sure there are plenty of “ifs,” but the point is that viable solutions are still within a reasonable range. We just need to ensure that we steer the ship in the right direction before we end up drifting completely off into the abyss.


I am no economist, but the directions are painfully clear. Stop spending unsustainable amounts, modify the tax code to ensure everyone pays a fair share, and reallocate resources to their most productive uses, net of a plan for retiring debt. As an added bonus, the Treasury should think about locking in historically low interest rates by refinancing and increasing the average maturity of its outstanding debt. Thirty year interest rates of 3% are unlikely to stick around forever. All easier said than done, we know. But, the point is, the solutions are still attainable and it is time to get moving. Seeing those movements transpire will certainly stoke our optimism. In the meantime, as investors, there will be risks and opportunities along the way. We will spend the rest of this letter pointing out some of things we see for 2013.


High yield hunting


The first observation, we think, is a side effect of public policy. Dr. Ben Bernanke (Chairman of the Fed) has made it clear that one of the primary objectives for QE is to lower certain interest rates. The belief is that lower interest rates can act as a catalyst for demand and credit, ultimately boosting economic activity. For example, QE has certainly caused Treasury rates across the yield curve to hover near historical lows.

However, there were also side effects. Though QE is focused on government securities, interest rates have been suppressed all across the board. This partly has to do with the actions of yield starved investors. After QE, fixed income investors who were accustomed to earning a 5% yield on a portfolio of government securities, were forced to accept a 2% yield for the same portfolio. The steep drop in yield was so insufficient and unacceptable that investors began hunting for yield. The easiest way to do that was to take on more risk.


Investors began flooding into riskier income paying assets, and everything from corporate bonds to REITs also ended up with historically low yields. Nowhere is this more prevalent than in the high yield bond market. According to Morningstar, high yield bonds saw the largest percentage based inflows in 2012 among all the asset categories it tracks. In addition, high yield bond issuance reached an all-time high in 2012, reflecting record demand. It is easy to see why, with 10 year Treasuries yielding less than 2%, a 6%+ yield can look very enticing. However, we think investors may be forgetting that high yield bonds are called “junk bonds” for a reason.


Junk bonds got that name because of the poor credit quality of the issuers and/or the weak terms of the underlying covenants (with respect to investors). They pay high yields because they have a higher risk of default versus investment grade bonds, it is that simple. With that in mind, high yield bonds are currently paying investors the lowest yields in absolute terms ever for taking on that risk. In relative terms as well, the 400 basis point spread to Treasuries is also below the long term average of 600 basis points. Figure 7 shows junk bond yields from 1988 to 2012, according to the FINRA/Bloomberg Active U.S. High Yield Bond Index.


Figure 7

Source: Bloomberg, BCM

Some will say that the low yields reflect the fact that default rates in the high yield bond market have been very low. Sure, that may be true. However, we think that abnormally low default rates are a terrible reason to be complacent. All else equal, below average default rates come with the risk of rising defaults, and should call for heightened vigilance, in our opinion. A good time for high yield bonds would have been 2009 when absolute yields and relative spreads both exceeded 20%. Currently, high yield is not attractive, in our opinion.


Cold, Hard, Commodities


We have been bearish on commodities for the past two years. Some commodities have outperformed others, and windows of volatility may have been good for trading, but we have not missed out on much in general. The broad commodity markets were down in both 2011 and 2012. That being said, we have also made the case for liking commodities from a secular perspective. The reasons are straightforward. Natural resources like oil, metals, and even livestock and agriculture are ultimately finite. At the same time, global demand increases every year. That much is clear.


What may be less obvious is the extent to which global consumption imbalances exist. Using oil as an example, the United States has a population of about 315 million people, and consumes almost 7 billion barrels of oil per year. That equals just over 22 barrels per person annually. Meanwhile, China has a population of over 1.3 billion, and consumes about 3.4 billion barrels of oil per year. That equals about 2.5 barrels per person. On average, Americans consume about 9 times as much oil as the Chinese (22 barrels versus 2.5). The fact is that the US consumes more oil per year than China, India, and Russia combined. This happens despite the fact that the overall population of China, India, and Russia is more than 8 times larger than that of the US. Figure 8 shows a summary of these disproportionate population and oil consumption numbers.


Figure 8

Source: CIA, BCM

This is an extreme imbalance, and it is probably only a matter of time before the billions of people in developing countries become developed enough to demand their own 22 barrels of oil. The same is true for just about every other commodity. Given our fixed supply of natural resources, it is reasonable to assume that long term commodity prices have significant upside potential. Worth noting, countries like China that used to love accumulating US dollar reserves have gradually cut back their holdings in favor of hard assets like oil and gold. If this trend gains popularity, it could accelerate price increases and even push them higher. That brings us our final point about commodities - prices.

As we have written in previous letters, commodities are difficult to value and price. This is because, unlike other assets, commodities have virtually no cash flows (i.e. interest, dividends, earnings, rent, etc.). That renders standard pricing and valuation tools (like discounted cash flow analysis) ineffective. Since intrinsic value is hard to estimate, fair value is often replaced with whatever price the next greater fool is willing to pay. This is one of the reasons that commodity markets can be very volatile and highly speculative. Fortunately, by using some simple assumptions we can come up with a reasonably sound estimate of fair value.


For example, assuming commodity supplies are finite and that demand for them will continue, we can expect commodity prices to at least keep pace with inflation over time (all else being equal). Of course there are plenty of variables we have not considered, however, at the most basic level this should make sense. With that being said, take a look at Figure 9 below. It plots the real price (inflation adjusted price) of the DJ UBS Commodity Index over the past twenty years (in blue). Also included, is a trend line (in red) which plots expected real prices based on a 2% inflation rate. Long term average inflation is closer to 3% or 4%, however 2% is a reasonable average for the period considered.


Figure 9

Dow Jones, BCM

Exception in equities


Our final look at the markets will be in equities. Overall, our outlook for the equity markets has not changed since last quarter. We continue to be cautious in general. With that in mind, we still think that foreign developed equity markets are the most attractively valued. Figure 10 shows the P/E multiples for US, foreign developed, and emerging market equities. Notice that while emerging markets have the lowest absolute P/E, they are not undervalued relative to historical averages and neither are US stocks. Foreign developed stocks continue to have the lowest relative valuation.


Figure 10


Source: Yahoo Finance, BCM

We may not be bullish on emerging markets, but there are always exceptions. In this case, that exception is Russia. Though India and China tend to get most of the attention, we should remember that Russia is the “R” in the “BRIC” acronym. Russia has much more to offer than just stiff vodka and comradeship. For example, Russia has a vast range of natural resources including timber, metals, coal, rare earth elements, and one of the world’s largest natural gas reserves. Russia is one of the largest exporters of steel and aluminum. In addition, and surprising to many, Russia is the world’s largest producer and exporter of oil. Yes, Russia produces and exports more oil than any country in the Middle East. These facts correlate well with our secular opinion on commodities, yet that is not the only reason why we like Russia right now.


Compared to other emerging market countries, we think Russia looks financially healthy, and that its equity market is attractively valued. Figure 11 shows some statistics we gathered for the BRIC countries. Notice that Russia has the highest current account surplus and lowest levels of debt (relative to GDP) compared with Brazil, India, and China. Brazil and India in particular have relatively high Debt/GDP levels. While Russia’s GDP growth is not “on fire” like in China, we think it is within a healthy and sustainable range. Russian inflation and unemployment are a bit on the high side, however they are by no means the worst (unemployment is lower in Russia than in the US). In addition, both measures have fallen significantly from their recent double digit levels, and they are both projected to continue improving.


Figure 11

Source: IMF, BCM

With those things in mind, the fact that Russian equities are trading with a P/E multiple of somewhere around 5x makes them worth looking at, in our opinion. Of course emerging market equities tend to have lower valuations relative to developed markets due to their perceived risks. Valuation swings as measured by standard deviation tend to be more volatile as well. Also, when dealing with emerging markets social, political, and even currency risks are always concerns. They are highly unpredictable and developments in any of those areas could the outlook overnight. Those things considered, we think that strong financial position, reasonable expectations, and low absolute valuations make the Russian equity market currently attractive from a long-term perspective. As usual, we would not recommend taking an oversized position. Instead, prudent investors can build a position over time as a part of a balanced and diversified asset allocation appropriate for their goals and needs.


The Bottom Line


Entering 2013 we maintain the same cautious stance that we did in 2012. Encumbering and uncertain public policies are certainly affecting our outlook, but they are not the only things shaping our views. We monitor other factors such as economic conditions and market valuations on an ongoing basis as well. Currently, our work continues to indicate that cautions risk management is the most appropriate action for prudent, long term investors. At some point more aggressive risk seeking will make sense, but meanwhile we sit patiently in the backseat, asking occasionally “are we there yet?”


As for the markets, we think high yield bonds are not paying enough in high yields. They look overpriced and over issued and the general complacency in the high yield markets make us nervous. Though we think commodities may have additional downside, but we are watching them with interest from here on. In equities, we continue to think foreign developed markets are valued more attractively than US and emerging market stocks. The one exception is Russian equities, which we think are under followed and attractively valued.


If you made it this far, then congratulations! This has been a longer letter than usual. For more frequent updates throughout the year, please see The Bellwether Blog.

As for now, thank you for reading and please feel free to contact BCM with any questions, comments, or needs.


Be Great,


Victor K. Lai, CFA


Bellwether Capital Management LLC (BCM) is a registered investment adviser (RIA). It provides investment management services for people and organizations. Please visit www.bellwethercm.com or to learn more.


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