Fall is upon us, and as the year draws to a close, the days grow shorter and the nights longer. There is a chill in the air as the leaves change from green to gold and red before falling to the hardening ground below. It is a time of harvest, thanksgiving, and reflection.
And it’s usually about this time of year, right around Halloween, that our elected officials seem to rise from their chambers to spook investors with their own frightening version of trick or treat. Grim Reapers and Death-Eaters move aside. You just aren’t that scary next to the fearsome sight of the U.S. Congress in full zombie mode, playing a game of chicken with the U.S. economy and global financial markets.
Last year, they led us up to the very edge of the dreaded “Fiscal Cliff.” This year, it’s a government shut-down and potential default on our debt if we don’t pass a budget and raise the debt ceiling. This should be routine stuff, but Congress has a unique gift for turning routine actions into existential crises to achieve some form of political gain, often at the expense of the broad economy and public it is presumably there to serve. It is no wonder that Congress enjoys a 10% approval rating, somewhat below that of Lord Voldemort and Darth Vader.
This is no way to run a country, especially in an evermore competitive global economy, but it is the system we have ended up with, as a result of a variety of factors including campaign finance and the role of special interest groups, as well as congressional redistricting. The result is a government that is in a constant state of battle with itself, where ideology trumps idealism, and where small groups have disproportionate bargaining power. As Lincoln famously said, “A house divided against itself cannot stand.” What was true for the nation then, remains equally true for both the nation and the Congress today. It is a wonder we get anything done at all.
For the most part, investors and business people have learned to ignore the political circus, and move on with their lives, with the expectation that in the 11th hour, somebody will blink and a temporary solution will be found. The can will get kicked down the road until the next self-induced crisis.
Like most people, we think the probabilities are good that right before we get to the brink of disaster, Congress will find a way to reach a deal. This will likely be the point when the political costs of inaction outweigh the political consequences of compromise.
What scares us a little is that this is also the current consensus opinion. We think investors are a little too complacent that this will all work out fine.
Although a last minute deal is the most probable outcome, Congress is playing with matches next to an open tank of gasoline. Accidents can and do happen. We are reminded of the failed TARP vote five years ago when the House of Representatives originally voted it down. Congress had a change of heart the next day, but that was only after watching the stock market decline 8%, wiping out over $1.2 trillion in market value. Whoops! Just kidding!
And so while it would surprise us if they don’t reach a compromise, it would not surprise us to see some volatility in the stock and bond markets in the next few weeks.
Meanwhile, despite the best efforts on the part of politicians to the contrary, the U.S. economy continues to recover, innovate and grow.
Chart I above shows the U.S. Purchasing Managers Index (PMI) for manufacturing and services, both of which show healthy readings around 55. A value above 50 typically indicates economic expansion. Some more recent economic indicators have shown weakness, but we think the overall direction of the economy is still positive.
Many investors, including ourselves, had expected the Federal Reserve to announce a formal plan to taper the purchase of Treasury bonds (aka “Quantitative Easing”) at its meeting last month. It did not, most likely in anticipation of the current budget and debt impasse in Congress. As long as Congress wants to play with matches, the Federal Reserve will keep the firehose of monetary policy fully open.
In reality, any tapering of extraordinary bond purchases will be relatively small and incremental. The absolute level of interest rates and borrowing costs are low by any historical standard and will probably remain that way for years to come.
Chart II shows the PMI manufacturing index for the U.S., Europe and China, all of which have inched back above the 50 level, also typically indicating renewed economic expansion.
After two years in recession, we think that the Euro-zone is finally moving back into a period of slow growth and recovery. The Chinese economy also appears to be stabilizing and returning to moderate growth.
All of these regions, including the U.S. have their respective challenges and opportunities. The global economic recovery is fragile, interconnected and vulnerable to external shocks. This is one reason why our own self-inflicted wounds seem so pointless not just to us, but to nations around the world that are also impacted by our actions.
Overall, despite its political dysfunction, we continue to think that the U.S. economy has a lot going for it and is well positioned for continued, although suboptimal growth. It is very diverse and balanced, with a healthy private sector, strong financial institutions and public markets. There are also many positive developments including remarkable innovation in technology, and biotechnology, a burgeoning renaissance in our industrial economy and a transformation in our energy sector just to name a few.
But given the strong performance of the U.S. stock market over the past year, both in absolute terms and relative to the rest of the world, expectations are high and valuation levels are full.
Chart III shows the performance of the S&P 500 index relative to the actual earnings of the companies in the index. The chart shows that during the first two years of the recovery, the growth in the stock market was driven primarily by growth in earnings, but that since the end of 2011, it has been driven more by an increase in the valuation that investors are willing to pay for a given level of earnings. In the last two years, the Price to Earnings ratio of the market has climbed from 12 to over 16.
Although 16 times earnings is not expensive by historical standards, it is not cheap. In a world of low interest rates and few other attractive opportunities, market valuation levels could remain here or easily get more stretched as investors chase returns, but we would prefer to see future appreciation driven by increases in corporate profits and improvements in fundamentals.
We still think that stocks offer the best long-term opportunities for capital appreciation, especially relative to most every other asset class. But given the strong performance of the U.S. stock market to date, current valuation levels and potential risks, we also think it is a good time to rebalance portfolios to favor more defensive stocks and strategies. Moreover, we think it is a good time to rebalance exposure between the U.S. and the rest of the developed and developing world, where expectations are lower and valuation levels are more attractive.
In last quarter’s commentary we pointed out the remarkable divergence between returns of various asset classes, and especially between U.S. stocks and almost all other asset classes including foreign stocks, commodities and bonds. We have started to see some of these imbalances correct, with both European and Developing market stocks staging a strong rebound. We expect these trends to continue.
Our outlook for bonds remains bleak over the coming years as interest rates begin their inevitable move higher. This may take longer than many expect, but it is hard to imagine rates going lower.
Given this outlook, we continue to focus the bond portion of client portfolios towards a combination of “Total Return” managers who have broad flexibility to pursue opportunities anywhere in the global credit markets, and Multi-Asset Class investments that have defensive characteristics like bonds, but also have the ability to benefit from economic growth.
Balance remains the key: balancing between a suitable mix of appreciation-oriented, defensive and alternative strategies; between a variety of asset classes; and between near-term and longer-term investment outlooks.
As always, we welcome your questions and comments.
The Essential Investment Wisdom of Bill Jurika.
Many of you may have heard that Bill Jurika passed away this past August.
Although Bill retired from active involvement in this firm several years ago, he was a great friend, business partner, and teacher, who possessed one of the finer investment minds we have met along the way.
Bill was a creative and fiercely independent thinker who never shied away from speaking his mind or challenging conventional wisdom and practice. He thought good investing at its heart was rooted in practical, common sense thinking and judgement. He was part optimist and part contrarian, believing in a better future, but also that the best opportunities were to be found, away from the crowds, on the roads less traveled. When the world zigged, Bill would start to zag. He was often early, but usually right in the end.
Over the years he developed a number of investment principles which have stood the test of time and are central to how we do what we do here at Jurika, Mills & Keifer. They should be part of any investors’ framework for looking at the world and making investment decisions. As a tribute to Bill, we thought we would share ten of them with you:
1. Markets are neither efficient nor rational. They are driven by investors who are emotional and can be counted on to take a good or bad thing too far. The history of the capital markets is a history of repeated booms and busts, of gross misallocation of capital and mispricing of assets. This creates opportunities for investors who are patient, keenly focused on fundamentals and valuation and indifferent to market sentiment.
2. Risk and volatility are not the same thing. Risk is the probability of permanently losing money. Volatility measures the degree of price fluctuation, most often to the downside, and can be a good thing. Rising volatility is often associated with declining prices and rising risk. In fact, when prices go down, although volatility rises, actual risk tends to decrease. Good assets become cheap and it’s time to go shopping.
3. Actual and perceived risk tend to be inversely proportional to one another. The greater the awareness of a risk, the more likely that the risk is already reflected in prices. The perceived risks of equities in 2007 was very low, when in fact the risks were high. By contrast, in March of 2009 the perceived risk of stocks was high and the actual risk was negligible.
4. Diversification is important but does not equal safety. When things go wrong, most assets have a way of correlating to one another and there are few hiding places. Overdiversification leads to blandness. It is hard to make a fortune or beat the market with a diversified portfolio. It is better to have fewer investments in which you have greater conviction. Bigger investments are not necessarily riskier.
5. Good investment decisions are usually uncomfortable and comfortable investment decisions are usually bad. You need to understand the critical difference between instinct and emotion and to be willing to buy when you - and everyone else - are fearful and things look bleak, and sell when everything looks rosy and almost too good to be true. The tops and bottoms of market cycles are marked by moments of maximum pain and euphoria.
6. Think for yourself and be willing to go challenge conventional wisdom. Widely held beliefs have a way of being turned on their head in time. In mid 2008 experts believed that oil was headed towards $150 a barrel, right before it started heading for $38. The crowd isn’t always wrong, but it is, by definition wrong at the extremes. It pays to have a healthy suspicion of widely held and extreme investment beliefs.
7. Stay Humble: Your greatest failures often follow your most recent success and vice versa. It is easy to confuse luck with skill. One great investment or market call does not guarantee another. Conversely, one bad investment call does not mean that subsequent investments are destined for failure. Be willing to take chances, make mistakes and learn from them. Focus on your strengths, understand your limitations and keep moving forward.
8. Your greatest fears and hopes rarely materialize. The world has a way of working things out, but never quite the way you expect. Learn to expect the unexpected, and unexpect the expected. Keep a balanced perspective.
9. Less is More. Keep things as simple as possible. Know what you own and why. Own good assets and stick with them through the inevitable ups and downs, as long as they remain fundamentally sound. Tune out the daily noise that crowds out bigger ideas. Understand the difference between information and insight.
10. Invest with purpose, focus and discipline. Have a point of view and a plan. Stick to it, making appropriate course corrections along the way. Be proactive rather than reactive.
Over the years, Bill touched not only our own lives, but the lives of many of our clients and countless others who were fortunate enough to have known and traveled with him along the way. We feel privileged to have had the opportunity to work alongside him and learn from him over the course of many years and to carry his values and investment principles forward.
Jurika, Mills & Keifer, LLC