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Where We Started

by Victor K. Lai, CFA

Year in review

2011 was an eventful year worldwide. It was a year that included natural disasters in Asia, financial crises in Europe, and the toppling of governments in the Middle East. Equity markets were in tune with the times and were as tumultuous as ever. Yet, despite the wide market swings, U.S. stocks ended up flat for the year. Based on price performance, the S&P 500 returned 0% in 2011. For equity investors, this resulted in a whole lot of anxiety and nothing to show for it. Meanwhile, the bond market produced a total return of 7.84%. Figure 1 shows the monthly price movements for the S&P 500 (blue) and the Barclays Aggregate (red) during 2011.

Figure 1

Source: Yahoo Finance, BCM

According to the stock market, we have literally gone nowhere for the past year. Looking back, I would say that sounds about right. Going into 2011 my concerns included rising debt levels, increasing federal deficits, weak economic growth, and overvalued markets. As things look right now, not much has changed. In fact, some things actually look worse. For example, the debt problems in the U.S. are now overshadowed by even worse debt problems in Europe. It should be no surprise, then, that my outlook for this year remains cautious.

The big picture

Going into 2011, the consensus on Wall Street was for a strong “V-shaped” recovery. That hasn’t happened yet and many people are now arguing that they were just early. One common argument I have read about is “pent-up demand.” It says cyclical industries like housing and auto reflect consumers are spending at unusually low

levels, creating a buildup in potential demand. For example, since vehicle sales have fallen below average levels, many people assume sales should increase moving forward (Figure 2).

Figure 2

Source: JP Morgan

The assumption is that once we start spending like normal again, economic growth will rise back to its pre-recessionary levels. That may or may be true, but it’s important to look at the other side of the argument. Taking a step back, we could say that consumption is not abnormally low. Rather, it was abnormally high. Over the past three decades, personal consumption in the U.S. rose to remarkable levels. It went from less than 2 trillion in 1980 to over $10 trillion in 2011. Figure 3 shows the annual personal consumption expenditures in the U.S. from 1960 to 2011.

Figure 3

To put that into perspective, the U.S. has been purchasing more goods and services per year than the countries of China, Japan, Germany, France, and the United Kingdom combined. There is no mystery as to how we funded that level of spending. We borrowed money, and lots of it. Figure 4 shows the annual levels of U.S. debt outstanding from 1960 to 2011. Clearly, our spending and borrowing increased hand in hand.

Figure 4

Excess is unsustainable. A period of overspending and excessive borrowing must eventually be offset by one of frugality and saving. It does not take much insight to recognize that a period of deleveraging is underway all across the developed world and it is turning the global economy upside down. Dr. Mohamed El-Erain (CEO at PIMCO) calls this reversal a “New Normal.” Jeremy Grantham (Chief Investment Officer at GMO) calls it “7 Lean Years.” Whatever we want to call it, the point is consistent. As individuals, businesses, and governments unwind their debts, consumption and the economy are unlikely to maintain the same growth that they did when credit and leverage were expanding.

Managing equity expectations

That is not to say that 2012 is the year of investing apocalypse. Investors just need to manage their expectations. For example, in a “New Normal” type of environment, it may not be realistic to assume that U.S. stocks will deliver the same 9% average annual return that investors have grown accustomed to. To understand why, we need to consider the makeup of equity returns. Equity returns are heavily influenced by earnings growth. In other words, the growth of a company’s stock price is influenced by the expected growth rate in that company’s earnings. While the earnings growth of individual companies may vary widely, the earnings growth of the stock market as a whole generally mirrors the growth rate of the economy over time.

The 9% market returns of the past were built on economic growth rates of 6% per year. If economic growth slows to 3%, then it is reasonable to discount equity returns commensurately. Of course there is a dividend yield component as well. Long term, dividend yields have averaged 3% – 4% per year, and many investors still use those yields for their return assumptions. However, the reality is that dividend yields have steadily declined for decades and have been hovering around 2% since the 1990’s. Figure 5 shows the dividend yields for the S&P 500 from 1980 to 2011.

Figure 5

Simple arithmetic tells us that 3% growth and a 2% dividend yield only amounts to a 5% total return. This is not to say that U.S equities are no longer capable of producing 9% returns, but that investors may need to demand higher discounts in order to achieve them. In other words, recognizing slower economic and earnings growth, investors may need to buy at lower valuations in order to achieve the same returns they received in the past. Please keep in mind I am not advocating “market timing.” My point is simply that equity investors may need to be more value conscious moving forward.

All that being said, equity exposure should ultimately be determined by an investor’s goals and needs (not valuation or other measures). In that sense prudent investors should maintain whatever allocation is appropriate for their circumstances. I think some timeless advice, regardless of market environment, is to avoid biting off more equity than you can chew (is appropriate for your circumstances). This bit of advice resonates especially well in periods when valuations are above normal.

Bonds delivered

Fixed Income yields surprised many people in 2011, myself included. With interest rates already at historic lows, bond yields managed to move even lower by year end. Figure 6 shows the monthly yields for the 10 Year Treasury note and the BAA Corporate Bond index during 2011.

Figure 6

Long dated Treasuries were the undisputed champs in 2011, and delivered a total return of 22.75%. Even Bill Gross, Chief Investment Officer at PIMCO and nicknamed the “Bond King,” was blindsided by the fixed income market. Gross sold off Treasuries from his flagship bond fund at exactly the wrong time, but it is understandable why he did so. Treasury yields were very low, government debt was ballooning, fiscal deficits were increasing, and the dollar was being “debased” by the Fed. Many investors were expecting Treasuries prices to fall.

So what happened? Anything and everything that was unexpected happened - natural disasters, political upheavals, and global economic crisis. When global markets sense fear, the United States and U.S. assets are still seen as a global safe haven. Like I wrote last year, in times of duress “better or worse” can be more important than “good or bad.” Sure, the debt problems in the U.S. were ugly, but relative to other problems that emerged, they did not look so bad after all. As a result global investors fled into U.S. Treasuries for the sake of safety.

While I share Gross’s opinions, fortunately I did not share his investment position. At BCM, we maintained Treasury exposure throughout 2011. Though low yields tempted us to underweight bonds, we maintained a neutral allocation due to uncertain macroeconomic conditions and ultimately that worked in our favor. Moving forward, it is important to recognize that Treasury yields have been falling for decades and are at historic lows. Figure 7 shows the annual yields on the 10 year Treasury note from 1980 to 2011.

Figure 7

Source: Federal Reserve, BCM

Dr. David Kelly (Chief Market Strategist at JP Morgan) describes current Treasury yields as “extreme.” Indeed, yields have reached extreme lows and cannot stay there forever. Yields will rise, that is a certainty in my opinion. Of course nobody knows when it will happen. Relying on market timing, whether for stock prices or yield reversals, is a losing proposition and even the “bond king” can attest to that. The prudent approach is to maintain a neutral fixed income allocation appropriate for your circumstances. To protect against unexpected increases in interest rates, I recommend keeping durations low.

Cash and opportunity

Cash is paying next to nothing, and is actually paying negative interest rates when adjusted for inflation. Investors may therefore think it is nonsense to maintain any cash on hand at all. Yet cash has hidden value due to “optionality.” It provides the holder with an option to act on investment opportunities when they appear. As of now, neither stocks nor bonds look especially attractive, so why should we overweight either? There is nothing wrong with looking for better opportunities. As such I maintain an overweight position in cash while hunting for bargains. I review some of the opportunities I am watching below, in no particular order.

Like I wrote last January, real estate is still one of my favorite themes. Though prices continue to fluctuate, it looks as though they may be close to finding a bottom. Figure 8 shows an index of national commercial real estate prices from 2001 – 2011. Prices managed to bounce a bit in 2011.

Figure 8

While peaks and bottoms are impossible to time, I think it is safe to say that real estate prices are no longer high, and are certainly low relative to where they were in 2007. Along with bond yields, interest rates are also near historic lows. For those who can access the cheap credit, the combination of inexpensive leverage and low prices make real estate an even more attractive long term investment. It is worth repeating “long term” because real estate cycles can be notoriously slow, and could take years to generate any return on investment.

Another area that I think has value is foreign equities. The growth in emerging markets is a well-known theme. As I wrote in July, emerging market equities are appealing long term, however they looked expensive in terms of valuation and I recommended dollar cost averaging into a position over time. Given that emerging market equities fell by more than 20% since August, this looks like an opportunity to “buy the dip” and to fill a tranche at lower prices. Keep in mind that emerging market stocks are very cyclical. They are sensitive to economic conditions and exhibit wider price swings than U.S. stocks. Price volatility and the potential for precipitous declines reinforce taking emerging markets in lumps rather than all at once. Figure 9 shows the price performance of U.S. (blue) and emerging market (red) equities in 2011.

Figure 9

Source: Yahoo Finance

When it comes to foreign investing, emerging markets tend to get all the attention. However, I think that foreign developed markets are also worth looking at. Europe is obviously in a mess. Greece, Portugal, Ireland, Italy, Spain, and even Belgium are all neck deep in debt. Individually, each country is either on the edge of default or has already jumped. With the Eurozone’s very existence being called into question, investors are fleeing European assets and selling anything related to the region.

The problem in Europe, like in the U.S., is too much public debt. That debt most likely will need to be “restructured” and bond holders will most likely take losses. Equity markets in general will not like that idea, and European markets certainly did not like it last year. Yet, we need to keep things in proper perspective. The economic engine in Europe is not dead and European equity markets are still capable of creating value. Be that as it may, frenzied sellers do not discriminate and everything must go in a fire sale. I do not know how low equity prices will go, but I do think that developed market valuations are attractive from a historical perspective and relative to emerging markets as well. Figure 10 shows the current and average P/E ratios for developed (EAFE) and emerging (EMEA) market equities as of December 30, 2011.

Figure 10

Source: Vanguard, BCM

While both markets appear to be undervalued, developed markets are trading further below their historical averages. I am not saying prices will not go any lower. The EAFE hit the single digit P/Es in 2011, and could certainly revisit those levels. I am saying that European assets are being sold off indiscriminately and that type of mass exodus often presents opportunities. Regardless of whether or not European equities have hit a bottom, there are likely to be some good values for investors who are willing to look.

Summing Up

Despite all that happened last year, it seems like we are starting 2012 right back where we began in 2011. The problems that troubled us then are still prevalent today. Debt to GDP continues climbing towards unstable levels and fiscal deficits are still running dangerously high. The government is promising to reduce spending and at the same time private consumption remains under pressure by stubbornly high unemployment, decreasing personal net worth, and stagnant real income growth.

Just as our problems have stayed in place, the solution for fixing them has stayed the same. Our country is still in need of responsible fiscal management and efficient resource allocation. Public policies that use good money to bail out bad companies do not qualify as such. Subsidizing over consumption and encouraging the accumulation of unproductive debt does not qualify either.

Though we can argue about what is best for America, I think most of us can agree that a higher standard of living for all Americans is important. To that end, we need policies that are designed to nurture healthy and sustainable economic growth, because economic growth is the tide that will lift or lower us all. With election season coming up, we have the uncommon, undivided attention of politicians. Red or blue, Democrat or Republican, we need to collectively remind our elected officials of their duty to implement responsible public policy. In the spirit of politics, I know this is all easier said than done.

That being said, it is important for prudent investors to maintain a properly balanced and diversified portfolio to withstand the volatile times and markets that may lie ahead. Despite our concerns with each, that allocation should include both stocks and bonds. Bargain hunters may find some value in foreign equities. Though fixed income yields remain very low, bonds are an important part of any balanced portfolio, and can be an effective hedge during times of risk aversion. I still think real estate is attractive. Low prices, the ability to borrow at low interest rates, and the potential for generating cash flow make real estate a good long term opportunity, in my opinion.

Thank you for reading. I hope you found our time together to be useful or at least informative. If you or anyone you know needs help or has questions about investing, please do not hesitate to contact BCM.

Be Great,

VIctor K. Lai, CFA

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


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