Counterpoint —
A Commentary of Jurika, Mills & Keifer LLC
First Quarter: January 2014

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Where to?

2013 was a remarkable year for the U.S. stock market, which rose over 30%, making it the best game in town.

It was also about the only game in town. Non-US developed economy stocks were up only half as much, and every other major asset class posted a negative return for the year.

Emerging economy stocks declined 2.6%, and gold and bonds, two conventional bastions of safety, took a drubbing. Gold was down a whopping 30% for the year, and bonds posted their first losing year since 1999, declining over 2%.

Where to?

Chart I below shows the performance of the major asset classes in 2013 relative to their 10-year average performance. It’s not a balanced picture: the developed world dramatically outperformed the developing world, as well as its own historical average returns; and risk-oriented investments dramatically outperformed defensive investments. Diversification led to diminished performance.

Chart 1

So where do we go from here?

In the near term, we could easily see more of the same. Investors tend to chase what has worked in the recent past, and shun what has not. Markets also have a tendency to move to irrational extremes before moving back into rational balance. But at some point soon, we would expect a change in the tides.

In particular, we would expect Non-U.S. equities to start outperforming U.S. equities. The U.S. economy is improving, but we think that the rest of the world is also on the mend. After the past year, the U.S. stock market is fully valued, a victim of its own success. It can stay this way or continue to climb, but the potential return relative to the risk becomes less and less attractive. By contrast, non- U.S. equity markets offer better value and greater opportunity, especially in the developing world.

Meanwhile, the outlook for bonds remains bleak as long as we are in a flat to rising interest rate environment. Although bonds underperformed their 10-year average return by a significant margin in 2013, as we will discuss below, this is because the historical return of bonds is higher than it is likely to be going forward. Bonds can provide a defensive bulwark in a portfolio but are likely a source of little or no return in the near term, at least without taking on significant credit risk.

Towards a more global and flexible, equity-oriented core.

Given these factors, we have been moving client portfolio allocations towards a more global, flexible and equity-oriented core. This involves:

1. Trimming exposure to aggressive growth strategies that had a banner year in 2013 and are now expensive.

2. Trimming exposure to traditional bonds and bond managers in favor of defensive equity exposure.

3. Adding exposure to Long/Short and flexible mandate equity managers who tend to have good defensive qualities, but can also get aggressive when valuation levels are cheap.

4. Increasing exposure to European, Japanese and developing Asian equities, primarily through value-oriented strategies.

Economic View:

We are optimistic about the U.S. economy and think that it has the potential to surprise to the upside this year. The U.S. is currently in the sweet spot of a number of favorable trends including low interest rates and a very supportive Federal Reserve Bank; a strong, diverse and innovative private sector; and abundant natural resources including cheap energy. Among developed economies, the United States is the least dependent on exports. Although our government is highly dysfunctional, Congress has moved back into hiding for the time being, allowing breathing room for individuals and businesses to move on with their lives.

Our baseline assumption is that we see a pickup in economic activity as we move into the year including rising employment and capital spending. Both of these factors would be positive for the economy, although they usually lead to lower profit margins for companies.

This is not to say that the U.S. is a garden of roses. We still have a massive and growing amount of public debt, a government that is only able to deal with large problems in a marginal way at the last minute, and an economy that is under the influence, if not addicted to, strong monetary medicine and artificially low interest rates. We are a long way from being clean and sober, but we are taking baby steps in the right direction.

Our concerns about the U.S. stock market have less to do with the health of the underlying economy than with the valuation levels of the market, which reflect fairly high expectations for earnings and forward guidance from companies. Results that fall short of this mark will likely lead to a correction in stock prices. We think that this would actually be a healthy thing.
 
Across the Atlantic in Europe, we see continued economic improvement, especially in the United Kingdom and Germany, but also in peripheral countries like Ireland, Italy, Spain and even Greece. France is the laggard. The European Central Bank, under Mario Draghi continues to be supportive in word if not action, and sovereign borrowing costs have in most cases returned to pre-Eurocrisis levels.

Europe, like the U.S. faces many challenges, including persistently high unemployment and energy costs, as well as high overall public and private debt levels. But the Eurozone has come a long way from the abyss two years ago and there is still a lot of room for improvement.

European stocks have also come a long way from two years ago, but remain about 30% below their 2007 peak, in comparison with the S&P 500, which currently sits 18% above its 2007 peak.

The emerging markets are much more of a mixed bag, and although they tend to get lumped together into common baskets, it is wrong to think of the developing world in monolithic terms. There is a big difference between countries and regions.

China remains the 800 pound Panda in the Global living room. Its new political leadership is trying to engineer a transition from an export to a consumption-driven economy, while also reducing the economy’s dependence on fiscal stimulus. China faces large challenges, including real estate bubbles and other forms of gross capital misallocation, as well as corruption and pollution. But it is the second largest economy in the world and, despite fears of a hard landing, China is still growing somewhere between 6% and 8% a year. Moreover, the Chinese government is sitting on top of $3.5 trillion in reserves and has significant resources to support this transition as needed.

By contrast, countries like Brazil and India are more reliant on foreign capital flows and have considerably higher borrowing costs.

We take a long view. Collectively, the emerging and developing world may have more growing pains in 2014, but they are growing, and we remain confident that in the coming five years they will account for the majority of all global GDP growth. Given that they are currently on sale, offering the greatest potential growth for the cheapest price, we think that it makes sense to increase client portfolio exposure. In particular, we are focused on the growth of the Asian consumer and investment managers and strategies that focus on this area.

Bonds: Fishing in an Empty Lake.

Over the past 30 years, interest rates have been in secular slide, declining from a high of 15.25% on the 10-year Treasury Bond in 1981 to a low reached last year of 1.47%.

Over the next five to ten years we think that interest rates face an inevitable climb higher as the economy improves and the Federal Reserve curtails its extraordinary bond-buying programs. This may not happen tomorrow, or the next day. Rates could stay low, or even decline in the short-term for a variety of reasons. But over the longer term, the inexorable trend should be higher and one needs to prepare for the eventuality.

Whether interest rates stay where they are or start to rise, bonds are unlikely to produce attractive returns, at least without involving significant risk. They have become the investment equivalent of fishing in an empty lake. The water is calm, and you might catch a few minnows, but hardly enough to sustain yourself or justify the effort.

The temptation for bond and income-oriented investors is to stretch for yield, fishing near the edge of the waterfall, and moving into bond investments such as junk bonds and bank loans that offer higher yields.

The problem is that these investments come with significant imbedded credit and liquidity risk, often involve leverage, and, in our view, offer an unfavorable risk relative to the potential return.

We would rather invest in defensive equities that we think offer considerably more potential upside relative to a similar downside risk.

We thought it would be interesting to go back to the peak of rates in 1981 and look at every significant period of rising and falling rates since then to see how both stock and bond investments perform under different environments.

Chart 2
Table 1

Although there are always other external factors that influence the outcomes such as the starting interest rate, inflation, monetary policy, geopolitical risks, the longer term patterns tend to hold. As Chart II and Table 1 above show, during declining interest rate environments, bonds tend to outperform stocks, but not by much. Conversely, during rising interest rate environments, stocks handily outperform bonds.

This has important implications for portfolio strategy and construction. Most conventional portfolio models are built in the rear-view mirror, factoring in the historical returns of bonds and other asset classes over the last 10-30 years. But what does the next 10-30 years hold for bonds? The future returns for bonds are likely to be quite different than the historical returns.

We still think bonds have a place in client portfolios as a limited line of first defense, for which we are willing to accept low returns for their safety and liquidity. But, it doesn’t make sense to us to tie up 30-50% of a portfolio – the traditional allocation to bonds in a conservative to moderate risk portfolio – in an asset class that is unlikely to hold its value in a rising interest rate environment. Nor do we think it makes sense to stretch for yield by moving into areas of higher credit and liquidity risk. As fabled market commentary Ray Devoe famously remarked many years ago, “More money has been lost reaching for yield than at the point of a gun.”

The main role for bonds in a portfolio should not necessarily be to generate income, but rather, to mitigate risk. Income, after all, can be achieved by selling principal, and long-term capital gains are taxed at a lower rate than dividends or income.

Every investment in a portfolio should be evaluated on a total return basis, considering the total potential return of the investment relative to its risks and correlation to other investments in a portfolio. Given our outlook, we would rather own more equity-oreinted investments that have defensive properties and can replicate some of the risk-mitigating role of bonds, while having a much higher likelihood of making a positive contribution to portfolio performance over time, and especially when interest rates are on the rise.

Some thoughts on diversification.

This leads us back to a broader and important discussion about diversification. As noted above, 2013 was a year when diversification hindered, rather than helped portfolio performance. The more diversified you were, the worse you did. So why not just put all your money into U.S. growth stocks?

We updated our asset allocation “quilt” chart. It shows the performance of various asset classes over each of the past ten years. The fact that it looks like a quilt indicates that asset classes vary in their absolute and relative performance from year-to-year, often significantly. It also underscores the fact that it is very difficult to predict what asset class is going to outperform and underperform from one year to the next. The financial markets have a way of making the maximum number of people, especially the experts, look stupid.

Chart 3

(Click to enlarge)

But investors have a tendency of chasing past performance, and this almost always ends badly. This is the investment equivalent of driving by looking in the rear-view mirror.

If, on January 1st of each year, you had put all your money into the best performing asset class of the prior year, you would have ended up after 10 years with a whopping 0.9% return! By contrast, if on January 1st of each year you put all your money into the worst performing asset class of the prior year, after 10 years, you would have ended up with a 68.9% return, underscoring the fact that there is greater opportunity investing against the crowd than with it, especially at the extremes.

But a diversified portfolio, including a representation of each asset class produced a 112% cumulative return over the 10 year period, with much less volatility.

Diversification and balance are always important, but especially after a year like last year, where results were so unbalanced. 2014 will likely turn out quite differently than 2013, and last year’s high fliers - U.S. stocks - are unlikely to stay at the top of the list in 2014. We think the rest of the World will start to perform better and have allocated client portfolios accordingly, while still maintaining a significant core exposure to the U.S.

Most importnatly, it pays to have horses in multiple races, and to take a long-term, and forward looking approach to investing.

As always, we welcome your questions, comments and referrals,

Jurika, Mills & Keifer, LLC
January 2014

Important Disclosures

Opinions expressed are those of Jurika, Mills & Keifer, LLC, and are subject to change.

Investments in securities involve the risk of loss. There can be no assurance that investment strategies referenced will be successful, or that investment objectives will be achieved. Past performance is no guarantee of future results.

This communication is neither an offer to sell nor the solicitation of an offer to buy a security or advisory services, which can only be made by the appropriate offering document.