Thoughts on the Current Outlook -- October, 2014

A few comments about risk…

At a point in time when many people think US stocks are very overvalued and even more believe that bond prices are in a bubble, we thought it made sense to talk a bit about risks we see.  But first a little background.  Howard Marks, Chairman of Oaktree, a highly-regarded investment firm, has written eloquently and extensively on the subject of risk.  He sets the stage this way:  “Here’s the essential conundrum: investing requires us to decide how to position a portfolio for future developments, but the future isn’t knowable.”

But even though we can’t know the future, we can still develop a plan to deal with possible outcomes in a logical way.  Indeed, we, like most investors, view the investing world as a series of possible outcomes each with its own probability of occurring.  Because each outcome only has a probability, we have no way of knowing in advance what will actually occur.  Back to Mr. Marks: “Risk means more things can happen than will happen…Many things would have happened in each case in the past, and the fact that only one did understates the variability that existed…Even though many things can happen, only one will.”

Rather than trying to predict the exact course of events, it is our job to try to tip the scales in our favor, i.e., make informed judgments about investments that are likely to succeed based on the events we believe are most likely to occur. Of course, we will almost always be wrong about the specific events (unless we are just lucky) but if we correctly choose those investments with more upside than downside, we and our clients should fare well over time.  Mr. Marks refers to this process as finding “asymmetries” – where the upside far exceeds the downside.  

Are bonds now riskier than stocks?

Applying this thinking to the current environment, we can readily see good and bad asymmetries in the bond world.  The very low yields on sovereign debt throughout the developed world can’t fall much further but those rates could certainly rise dramatically, if growth and inflation were to be ignited.  This is particularly true in continental Europe and Japan where we believe the downside risk to bond prices is much greater than the upside – the bad kind of asymmetry. 

Further amplifying this risk, the Japanese and European central banks are firmly in stimulus mode.  Japan is much further along and the jury is still out on whether they will be able to jumpstart the economy.  So far they have succeeded in weakening the yen dramatically and spurring sporadic growth.  While a weaker yen might boost reported inflation, it could be counterproductive if rising import prices dampen economic growth.  In Europe, the central bank is just beginning its quantitative easing program and the only result so far is a significant drop in the common currency.  Due to limitations unique to the Eurozone situation, this program will have a tougher time succeeding.  In addition, it has a big near term challenge in overcoming the negative effects of the sanctions against Russia on the Eurozone economy.  Bottom line, both central banks are working hard to boost their economies and, if they are successful, rates will rise significantly.  For these economies, we believe the answer is yes, bonds are much riskier than stocks.  

Here in the US, the Federal Reserve is near the end of its bond purchase program and will likely begin raising short term rates sometime next year.  Unless we get some spark of inflation, however, we expect those rate increases to be relatively modest.  With energy prices recently declining and wage pressures non-existent, reported inflation is likely to be benign. So we think a large increase in US rates is unlikely but a modestly higher range of rates, particularly for short and medium term debt, seems like a quite reasonable outcome.  However, we can buy fixed income closed end funds at very high discounts to net asset values (reflecting investors’ belief that a large increase in rates or spreads is around the corner) which we believe provides our clients a good asymmetry.  In addition, high yield and floating rate loans provide good yields relative to inflation and higher quality bonds.  For the US market, we don’t think carefully selected bond investments are riskier than stocks.  

Stocks aren’t cheap either

Among US stocks, we have thought small caps were overvalued for a long time.  We were wrong in 2013 but have been proven correct so far in 2014 as small caps have drastically underperformed large caps.  However, even among large cap companies, we are finding it difficult to find high quality companies trading at reasonable values.  One particular concern of ours is that many very good, but slow-growing, companies are trading at very high multiples on earnings.  Typically, these stocks would be safe havens in difficult markets – that may not prove to be true if the market decides to mark these multiples down to more reasonable levels.  

To some extent, stocks are levitating based on a lack of alternatives (many perceive a higher risk in bonds) and a general skepticism that the bull market cannot last much longer.  How long this will go on and how it will be resolved only time will tell.  For now, we are paying very close attention to individual stock values, relative to the earnings growth expected.   

Outside the US, valuations are much less challenged so we added significantly to international stock fund positions earlier this year.  This proved premature this quarter as the dollar strengthened dramatically and international stocks, with the exception of a few markets, slumped.  However, leaving China aside, prospects for better economic growth are good in the coming year and this should provide a positive environment for stocks.  

In China, the gradual growth slowdown continues, making it hard for investors to handicap the stock market.  As a result, valuations remain low.  We believe China is heading for mid-single digit GDP growth with a greater share of its economy comprised of consumer spending.  What we find hard to discern is how the dichotomy between the government’s more market-oriented economic policies and crack down on political freedoms will play out.  

Finally, we continue to increase positions in hedged investments which provide some exposure to equity and debt markets but with lower market exposure.  Fortunately, more successful hedge fund managers are bringing their strategies to mutual fund form, providing us access to a much broader array of managers and strategies than ever before.

October 8, 2014                   

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