Thoughts On The Market & Investing: Our Strategy for Portfolios in the Post-2008 Environment
Thoughts on the Market & Investing Our Strategy for Portfolios in the Post-2008 Environment The Foley Group September 2010Having come through one of the most significant financial disasters of modern times, and withthe economic recovery remaining notably tepid, we thought it might be useful to examine thestrategic thinking that underlies our portfolio construction process. We believe that conditionsmay remain challenging for years to come. If that is the case, investors will have to work hard toachieve positive results. The purpose of this letter is to describe our vision of what is to come,and our plan for dealing with it.OutlookWe are a society mired in debt. Conspicuous consumption reached absurd heights in the yearsleading up to the economic collapse. Americans drained equity from their homes to fundspending. There were some particularly ugly examples of foolishness, wretched excess, andoutright fraud in the corporate world. Meanwhile, government regulators and credit ratingagencies seemingly turned a blind eye to the growing risks. In 2008 it all came crashing down inthe most dramatic economic crisis since the Great Depression. At that point, through bailoutsand an attempt to spur a recovery, the U.S. Government added unprecedented levels of debt towhat was already a considerable national burden.With our nation so indebted and facing huge healthcare and Social Security obligations, we feara prolonged period where rapid sustained growth will be difficult to achieve.After trending lower for nearly three decades, the savings rate among American consumers hasrisen in the wake of the crisis. That’s a positive development and will ultimately make us a morefinancially healthy nation. But if the trend toward saving continues, consumer spending will notbe the economic driver it once was. Meanwhile, government debt is likely to act as a brake onthe economy. As growth returns and interest rates push higher, those rates will impact theenormous debt, raising costs and slowing things back down. Taxes will rise to deal with thepressures of debt and social welfare obligations, providing another hindrance to growth.There are long-term market trends that seem to dovetail with the idea that economic headwindswill be with us for a while. Bull or bear market trends are sometimes referred to as being either
cyclical (fairly minor in impact or duration) or secular (significant and prolonged). There werethree secular bear markets during the last century: 1906-1921, 1929-1949, and 1966-1982. 16years, 21 years, and 17 years. If we are in the midst of another secular bear market, it began in2000. That puts us ten years in.So if we accept (or even just fear) that we are a bit more than halfway through the fourth secularbear of the modern age, the question becomes: what do we do about it?In difficult times it may be tempting to throw in the towel and park your assets in the “safety” ofcash, but that means accepting the certainty of a predictable loss over the uncertainty of anunpredictable loss or gain. Inflation, with rare exceptions, will eat away at your holdings everysingle year. Would you put your money in an investment that returned a negative 3.43% onaverage, year after year? That is the reality of inflation. It is an intangible danger that lacks thedrama of a market crash, but the impact is real, and can be devastating for its relentless nature.In a storm you give considerable thought to how well your boat is constructed. So it is withinvestment portfolios right now. In an effort to invest as well as we can in a time when getting itright might really matter, we have undertaken an analysis of investment theory on a number oflevels, and we have reached some conclusions that are impacting our approach.
Active vs. PassiveThere is perhaps no greater debate in the world of investing than active vs. passive. It is aselemental as the toilet paper question: “over or under?” (the correct answer to that is “over”, bythe way). Central to the issue is whether markets are efficient or not.One side argues that so much information is available, and the market in aggregate is so wellinformed, that nothing is to be gained by attempting to game the system through activemanagement of investments. This philosophy argues for index investing. Using indexes –essentially unmanaged “baskets” of stocks - has certain unquestionable advantages. First of all,it can help keep expenses low. Paying less in expenses is one of the few “sure things” in theinvestment world: lower expenses translate directly to the bottom line. Index or “passive”investing also has advantages in terms of tax efficiency, because a low level of trading helpsminimize realized gains, providing tax deferral. Finally, studies have shown that the averagemanaged fund fails to provide index-beating returns.While there is certainly merit to the index argument, what do you do about an index that isn’theaded anywhere? The S&P 500 is the one most commonly tracked by investors. Over the pastdecade, that index has returned nothing (actually, as of 9/15/10, it has lost money when you lookback ten years) . The concept of set it and forget it (aka “buy and hold”) does not work in asecular bear market the way it does when you are riding a consistent trend higher.Also, in recent years index investing has become so popular that we worry indexes may becomesubject to greater volatility than in the past. Large institutions utilizing computer-driven tradingprograms add to this concern. In short, we fear that indexing may have become a “crowdedtrade”.A final counterpoint to the indexing argument is that certain sectors seem to favor activemanagement, as do certain market conditions. To quote a white paper Baird recently publishedon the subject (available upon request): Evidence suggests that certain market conditions favor active or passive management. Actively managed investments have historically performed better than passively managed investments when the markets are decidedly negative, or in flat-to-moderate markets. Conversely, passive investments have generally outperformed in swiftly rising markets.Believing that the U.S stock market is likely to encounter further struggles in the years ahead, wefeel some degree of active management will be needed. That can come by way of choosingamong indexes, or it can come in the form of active management of individual securities. In ouropinion, it is wise to apply a bit of both.We find that active management is particularly important in the realm of alternative investments,a category that is meant to provide low correlation to the stock market. Which brings us to thesubject of diversification.
Hyper-DiversificationLet’s start with the problem of diversification, as highlighted by the global economic crisis of2008: it is hard to come by, especially when it matters most. Globalization is one factor. It usedto be that if you owned stock in American companies, some in Europe, and some in Asia, youowned a variety of investments that would not tend to dance to the same tune. In the modern agethose economies are more closely linked, each reliant on the other to some degree. An evenbigger concern highlighted in ’08 is that in times of crisis “all correlations go to one” (everythingtends to move in the same direction).Despite its limitations, we think it is a mistake to underestimate the power of diversification.First of all, even in the highly correlated economic meltdown, some things performed better thanothers. Moreover, when you expand the time horizon diversification still proves to be veryeffective. Note the example below, which examines results from 1990-2009: The Importance of Process The Average Investor Lack of a disciplined investment process hinders investment resultsSource: “Quantitative Analysis of Investor Behavior” Report, 2010, Dalbar, Inc. (January 1990– December 2009)This material is for illustrative purposes only and is not meant to represent any specific investment allocation.1 The Average Equity and Fixed Income Fund Investor returns are based on monthly industry cash flow reportsfrom the Investment Company Institute.2 The Average Market Timer return is calculated by subtracting the Systematic Equity Investor return (aninvestment made in equal monthly increments for the 20-year period, using S&P 500 performance) from theAverage Equity Fund Investor return.3 Inflation is based on the U.S. Consumer Price Index.4 The Diversified Portfolio is represented by the following allocation: 17.5% Russell 1000 ® Growth Index (Large CapGrowth), 22.5% Russell 1000® Value Index (Large Cap Value), 2.5% Russell 2000® Index (Small Cap), 7.5%Russell Midcap® Index, 10% MSCI EAFE Index (International stocks) and 40% Barclays US Govt/CreditIntermediate (Fixed Income securities). The Russell Indices are a trademark of the Frank Russell Company.Russell® is a trademark of the Frank Russell Company. Indices are unmanaged and one cannot invest directly in anindex. Past performance is no guarantee of future results and diversification does not ensure against loss. AllRisk/Return data is based on a 20-year period ending December 2007.
Further, if we accept that the U.S. market may be stingy in the years to come, we have goodreason to seek returns elsewhere. Not knowing exactly where the best returns will be found, weintend to cast a very wide net, using profits from areas of strength to buy into areas of weakness.Here are a few examples (in addition to more traditional asset classes):Global Real EstateGlobal BondsCurrenciesCommodities (oil & gas, precious metals, water, agriculture, etc.)Long / short strategiesManaged futuresExpectationsThere is a price for high levels of diversification: we will not fully participate in a roaring marketin any one particular asset class. If we are wrong about the US market and it proves to beparticularly strong, our heavily diversified portfolios are likely to lag. That is the tradeoffbetween risk and reward. If we seek to smooth out performance, to lessen exposure to marketcollapses, we will sacrifice participation during extreme spikes to the upside. Believing as we dothat the years ahead may be characterized by elevated risk and muted returns, we view that as areasonable price to pay.There are still big gains to be had by those willing to gamble in the markets, and fortunes will bemade (and lost!), but investors should know that shooting for large returns means puttingprincipal at greater risk. It is a fundamental and inescapable relationship.The investment business has traditionally viewed the risk / reward tradeoff from the perspectiveof risk tolerance (hence the ubiquitous “risk tolerance questionnaire”). In an upward trendingmarket this is generally an effective approach. The theory being that if you can tolerate highlevels of volatility you can keep a large proportion of your money in stocks, and achieve bigreturns over time. In a secular bear market however, this approach might prove terribly flawed.Higher stock exposure might not mean higher returns; in fact it could mean quite the opposite.Just as during difficult markets correlations between asset classes increase, we see increasingcorrelation among investors in terms of their appetite for risk, and their investment goals. Itmay no longer be as simple as swinging for the fences early in life, and then playing it safe whilein retirement. All investors want to come out ahead, and all want a measure of protection alongthe way.In simple terms we think the appropriate objective right now is to obtain some modest degree ofreturn above inflation, while striving to minimize volatility in the process. To grow and toprotect (while in many cases drawing income). Those are always the goals, of course, but in asecular bear market they come into sharper focus. All aspects of investing require greaterscrutiny in a difficult environment.
SummaryWhen it comes to investing we do not claim to have all the answers. In fact, central to our thesisis a belief that the answers are not entirely available. Rather we have a plan, a process that wefeel is grounded in sound fundamentals. Broad diversification, a focus on costs, constantresearch, and continual adaptation to market conditions will be our primary tools of portfolioconstruction and management.As we consider the possibility that we are only part way through a protracted stretch of economicdifficulty, we would do well to remember that there are cycles at work. Each such period ofstruggle in the past has been followed by a period of great prosperity. We believe it is the natureof a free capitalist society in distress to repair, innovate, and grow. While seeking to investcorrectly for the present and foreseeable future, we remind ourselves that we are also trying toset up for success in the days that lie much further out of view. Time flies… invest accordingly. ____________ The Foley GroupMichael C. Foley Janet G. Kelly Patrick M. Foley, CFP®,QPFCSenior Vice President Assistant Vice President First Vice President(215)553-7832 (215)553-7829 (215)553-7821 Visit the Group website: www.foleywealthmanagement.com Important DisclosuresPast performance does not guarantee future results. Diversification does not ensure against loss. Any transaction that mayinvolve the products, services and strategies referred to in this presentation will involve risks, and you could lose your entireinvestment or incur substantial loss. The products, services and strategies referred to herein may not be suitable for all investors.While further diversifying a portfolio with alternative investments can help to reduce risk, this asset class can include higher fees,greater volatility, higher credit risk, can be more complicated, less transparent, less liquid, less tax friendly, may disappoint instrong up markets and may not diversify risk in extreme down markets. You should consult with your Financial Advisor prior toengaging in any transaction described in this communication.Robert W. Baird & Co. Incorporated