The Importance of Low Volatility in Portfolio Returns
We took a more detailed look at the returns of the Essential Growth Portfolio℠ for the last several years, examining the trailing twelve months’ return at the end of each month. At the height of the bull market in 2007, the Essential Growth Portfolio℠ lagged the very strong returns of the S&P 500® by 700 – 800 bps. Conversely, at the depths of the bear market in late 2008 and early 2009, the Essential Growth Portfolio℠ lost 700 – 800 bps less than the S&P 500®.
This return pattern is exactly what we set out to achieve when we designed the investment process. A question we often get is: why does it matter so much to be down less if you are going to lag on the upside?
This a great question because the math is not intuitive. If my portfolio is down 5% and then back up 5%, I am even right? Well, almost. A $10,000 portfolio with the down 5%/up 5% pattern is back to $9,975. Not much difference you say. And we would agree.
But, if we take this example several steps further, you’ll begin to see the importance of minimizing volatility. The table below shows the two year, ten year and twenty year values of portfolios that are up and down 5, 10 and 15% each pair of years.
| Value of $10,000 | Up 5%/ Down 5% | Up 10%/ Down 10% | Up 15%/ Down 15% |
| After Two Years | $9,975 | $9,900 | $9,775 |
| After Ten Years | $9,876 | $9,510 | $8,924 |
| After Twenty Years | $9,753 | $9,044 | $7,965 |
Note: it doesn’t matter whether you are down first or up first in each pair of years, the results are the same.
You get the point -- the more volatile the portfolio returns, the harder it is to make back the losses. So, by trying to lose less, we also don't have to take greater risks to earn back the losses.
We believe this approach serves our clients' best interests. It may not be exciting but after the events of the last couple of years, less exciting sounds pretty good.
Annual Investment Outlook 2010
In 2009, the gloom of the first quarter gave way to euphoria in the financial markets in the last three quarters, as investors rejoiced that we had avoided a depression. Instead, we experienced a so-called Great Recession. If you look at the decline in GDP, this recession was roughly on par with the severe recessions of the early 70s and early 80s, with aggregate GDP dropping about 4% from peak to trough.
We believe that four other factors will give the Great Recession its lasting reputation: (1) very high unemployment and underemployment that will last for several years; (2) consumers have begun to pay down the astounding levels of debt they accumulated over the last two decades and the nation’s saving rate will rise significantly; (3) bank lending will remain on hold for much longer than is typical in a post-recession period as banks take several years to rebuild their battered capital bases and adjust to more stringent regulatory requirements; and (4) housing will continue to be a drag on the economy as foreclosures and excess supply keep downward pressure on prices.
While many of the government’s actions over the past two years have been designed to restore stability and confidence in the financial system, other actions have created uncertainties that we believe will weigh on the economy in the coming year. In particular, uncertainties regarding health care costs and income tax rates may cause small businesses to be more reluctant than normal to create new jobs. And, extraordinarily high deficits leave open the distinct possibility of much higher interest rates in the future, effectively crowding out private borrowing, traditionally the source of capital for small business job creation. It is also tough to sort out the impact of stimulus programs for cars, housing and state/local governments – did these programs provide a bridge to a better environment or will problems resurface when stimulus ends? Finally, a protectionist orientation has been growing in our trade relations with Asia, which may limit U.S. exports, a promising source of growth in a weak dollar environment.
On the positive side, we see a bifurcated consumer recovery. Affluent consumers – those with high incomes and somewhat restored net worths – have begun to spend once again. Those with lower or no incomes will continue to struggle mightily, with full employment difficult to come by. Businesses that had drawn inventories down to very low levels will need to rebuild their stocks to meet nascent demand. All in all, we expect the economy to post positive, but anemic, growth of 2-3% in 2010.
Corporate profits will continue to benefit from the draconian cost cuts put in place in late 2008 and 2009. With revenues rebounding somewhat on top of a lower cost base (and financial stocks providing a positive contribution as write offs begin to fall), aggregate profits should show a very healthy increase in 2010.
Missing from the Great Recession has been the high level of credit defaults predicted a year ago. With liquidity having returned to the bond markets quickly, many issuers have been able to refinance ahead of maturities. Most affected are those smaller businesses that depend on bank lending, where defaults and charge offs continue at a high rate. In the public debt markets, credit spreads have collapsed to average levels.
On the international front, we continue to believe in the long term story of the growing middle classes in the large emerging markets. China will continue to be a major source of global growth, as will India. However, that growth will become more internally focused, rather than export- or outsourcing-focused. The command structure of the Chinese economy gives us some concern about potential excesses but the sheer size of the economic engine they have created ensures its growing dominance of the region. The European Union will continue to struggle with very slow growth and the debt problems of some of its lesser members, while the resource-dependent economies of Canada, Australia and Brazil fare well in a healthy commodity pricing environment.
In retrospect, we were wrong in not hopping aboard the risk train in the early spring of 2009. Instead, we were content to take a much lower risk approach to earning very strong absolute returns for our clients, focusing on high quality U.S. stocks, international stocks and corporate/municipal bonds. Despite investors’ newfound appetite for risk, we do not think this is the time to significantly increase exposure to riskier equities. However, high quality stocks offer attractive return potential, particularly given the outlook for much stronger earnings in 2010. Many of the companies represented in the Essential Growth Portfolio℠ are heavily invested in the growth of developing markets. When valuations warrant, we expect to continue to increase direct exposure to these areas of long term growth. In addition, we plan to maintain a small but dedicated exposure to a broad-based basket of commodities.
In the fixed income area, we have brought durations (exposure to interest rate increases) down and quality up, as most of the easy money has been made. We have added exposures to non-U.S. debt securities and merger arbitrage strategies while continuing to exploit special situation opportunities in fixed income closed end funds.
As 2010 progresses, there is a wide range of variables that could have unexpected impacts on the global economy and financial markets. These include: withdrawal of US monetary and fiscal stimulus, demand for the large supply of U.S. government debt, ever-present geopolitical risks in the Middle East, actions of Congress on health care, tax policy and financial regulation, sovereign debt problems in southern Europe and terrorist activity, just to name a few. With the economy growing very slowly, an unexpected setback could easily trip the economy back into negative growth territory.
We remain very cognizant of the dramatic increases in market values we have witnessed since last March, virtually without correction. Investors’ current complacency can swiftly be replaced by fear arising from unexpected events beyond their control. In this risky environment, we are keeping client portfolios very broadly diversified and closely monitoring downside risk, relative to return potential.
January 6, 2010
© Essential Investment Partners, LLC
Chuck Jaffe Interview with Jerry Paul on Closed End Funds
Chuck Jaffe, a well known financial columnist for MarketWatch, interviewed Jerry Paul yesterday on the topic of opportunities in closed end funds. The article summarizing the interview is available at http://www.marketwatch.com/story/be-open-to-closed-end-bond-funds-2009-10-21?siteid=yhoof.
The article does a very good job of outlining the fundamental premise we utilize in investing in closed end funds: this is an underfollowed segment of the financial markets that may give rise to unique opportunities for those who spend the appropriate time researching potential investments and understanding the potential risks.
Please understand that opinions reflected in this article are NOT recommendations to buy or sell specific securities. Our opinions regarding markets and individual securities may change daily and without notice. Holdings of individual securities on behalf of clients change frequently and there is no assurance that specific holdings mentioned in the article will be held for any length of time.
Inflation or deflation – which is it?
We recently put together a white paper entitled “Inflation vs. Deflation – The Most Important Investment Decision You Can Make in the Next Five Years.” We supplemented this white paper with additional data that Jerry Paul presented to the Denver chapter of the American Association of Individual Investors in late September.
Not just an academic exercise, these studies pointed to several changes in investment strategies for our clients. In addition, they provide some data points for investors to keep an eye on over the coming months as these might provide clues to a shift in the interest rate climate.
The white paper is available by clicking here.
Harvard Describes Benefits of “Hybrid Model”
If you have taken a look at our website, you will see that our investment processes are a hybrid of internally managed investments and a selection of external managers. We strongly believe in this model as the most effective way to manage our clients’ investments.
In the September 2009 Harvard Management Company Endowment Report Message from the CEO, President and CEO Jane L. Mendillo describes the benefits of the hybrid model as Harvard sees them. We couldn’t agree more so we’d like to share her eloquent description:
“While we have made many changes in recent times, we continue to emply a ‘hybrid model’ – a unique approach to endowment management. We use a mix of internal and external management teams that focus on specific investment areas. We believe this gives us the best of both worlds – top-quality investment management by our internal team and access to cutting edge capability from specialized teams around the world…we will use the mix of internal and external managers that best represents our conviction regarding opportunities and gives us access to the best possible strategies.
The benefits of the hybrid model and both broad and deep:
- Harvard’s partnerships with investment management teams around the world provide diversification, insight, and perspective that goes beyond what could possibly be achieved through our relatively small team in Boston;
- Our internal investment management team…is our eyes and ears on the markets – constantly attuned and responsive to changing conditions, and frequently ahead of the curve in recognizing market inefficiencies and ways we might profit from them;
- In addition to this close feel for the markets, our internal management approach gives us increased control, total transparency and greater nimbleness in the face of changing market conditions…Finally, our internal team in extraordinarily cost effective – with total expenses equal to a fraction of the costs of employing outside managers for similar asset pools with similar results.”
While the scope, scale and range of the Harvard Endowment investments far exceeds those available to Essential Investment Partners and our clients, the shared philosophy of combining internal and external management to greatest effect is an important tenet in successful investment management.
Cost Cutting Key Theme in Quarterly Earnings Reports
Beating expectations has become quite commonplace among the companies held in the Essential Growth Portfolio. The second quarter’s earnings reporting season is a little more than half over for us and the scorecard looks pretty good. 15 companies have exceeded consensus earnings estimates, four have met expectations and three reported disappointing results.
Beneath these generally cheery headline results though lays a sign that this harsh recession is far from gone. With a few notable exceptions, companies have been able to beat expectations by cutting expenses more than analysts had expected. Revenue declines are still the norm and most companies have issued guarded outlooks for revenue growth in the coming quarters. The exceptions have been in health care supplies (typically recession-resistant) and outsourcing (helping others cut costs).
As a result of the top line strain, most companies intend to hold very tight on their expense controls – limiting hiring, restricting raises and bonuses, reducing travel expenses, deferring capital expenditures – until they see clearer signs that demand for their goods and services is accelerating.
We continue to believe that the markets have run well ahead of the underlying economic fundamentals. While it is certainly encouraging that the economy is no longer shrinking as quickly as it was late last year, we believe that strong economic growth in the near term is very unlikely. We could get some growth as companies restock inventory this fall, after having drawn down inventories to very low levels. However, this bump is likely to be temporary as most companies will be slow to rehire workers, instead raising the average work week from its current low level and supplementing those hours with overtime as necessary. Those who stay employed will continue to pay down debt and increase their savings.
Investment Outlook, July 2009
“Once-dreadful financial and economic metrics are now merely bad.” This line, from a recent publication by Morgan Stanley Smith Barney LLC, captures the essence of the “optimism” that has pervaded market thinking for the last few months.
This optimism brought the US stock market a very strong return of nearly 16% for the quarter. Not to be outdone, corporate bonds rallied too, bringing spreads versus comparable Treasury securities down to typical recession levels. And, municipal bond prices rallied while Treasury prices fell, bringing municipal yields closer to their normal yields relative to taxable alternatives. While we too prefer to be optimists, we think a dose of realism is most important at this point.
“Less bad” is better than “bad” but it is a long way from “good.” We do believe that with timely and mostly correct actions by policymakers, we have avoided an economic and financial meltdown. However, the markets have rallied to a level that real economic progress is needed to continue the advance. We don’t expect progress to be quick so we expect stocks to tread water or even move lower from here. As we have said previously, there are many reasons why restoring economic growth will take some time and it will come slowly.
The unemployment rate has now jumped to 9.5% and job losses so far this year are estimated at well more than three million. The ranks of the under-employed continue to grow as the average weekly hours worked number continues to fall. It is now clear that the unemployment rate will top out in excess of 10% during this recession. Even though growing unemployment bodes ill for consumer discretionary spending, it also means that companies are making themselves leaner and more efficient. When revenue does begin to turn around, corporate profits should bounce back pretty quickly. But aggregate consumer demand will remain tepid, making this profit recovery uneven.
The savings rate for individuals surged to nearly 7% in May, up from near zero over the past few years. We expect the savings rate to stay at this level or move even higher over the next couple of years as consumers rebuild their “personal balance sheets.” This means a greater focus on paying down debt (aggregate consumer credit outstanding has been dropping since September, 2008) and adding dollars to savings to replace value that has been lost through falling home and stock prices. These are positive trends for the long term health of the U.S. economy but in the short run, they mean less discretionary spending and lower growth.
Who would have thought a year ago that we could absorb the bankruptcies of GM and Chrysler within a matter of weeks without endangering our entire economy? Well, with Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers and AIG all going bust ahead of the automakers, the markets, policymakers and creditors were all much more prepared than for the others that went before. These bankruptcy filings will allow GM and Chrysler to dramatically restructure in ways that would have been nearly impossible outside of bankruptcy. The short term pain will be great but the result will be a healthier, more competitive manufacturing sector over the longer term.
We were happy to see the government allow the healthiest banks to repay their TARP money. Policymakers wanted to make sure that those who repaid now won’t need to come back to borrow again in the next year or two. Perhaps most important was that this first test of a government “exit strategy” from the private sector worked reasonably well. There are many more private sector investments the government will need to exit in coming years – we expect that some of the others will be more difficult to navigate.
Another positive development in the second quarter was the resumption of companies issuing debt. Starting first with the highest quality companies and later continuing down to lower rated companies (although still excluding the lowest rated), companies found surprisingly strong demand for their debt securities among investors. This healthy functioning of the credit markets is critical to the functioning of the US financial system and investors’ spirits were raised by the sense of movement toward “normalcy.”
Finally, concerns about the prospects for re-emergence of inflation entered some investors’ minds during the quarter. While we believe it is reasonable to have some inflation-protected investments as part of a well-diversified portfolio, we continue to believe that deflation, not inflation, will be the problem we will likely battle for the next few years. Labor markets are exceptionally weak and are likely to stay weak for some time so labor demands simply won’t be a contributor to price increases. Similarly, capacity utilization is very low in industrialized countries so there is a great deal of slack to be taken up before supply shortages could contribute to inflation. Commodity prices alone are not likely to drive inflation because they don’t represent a large enough share of production costs to drive a sustained increase in prices. Finally, the large government stimulus is only inflationary if the velocity of money stays constant or increases. All indications are that velocity has likely fallen recently, as it has in similar periods in history.
We continue to maintain a conservative investment posture. Despite the rally of the second quarter, bonds continue to offer very attractive returns relative to long term expected returns on stocks. Within stock allocations, we continue to use the Essential Growth Portfolio℠ alongside mutual funds that tend to offer more downside protection. We remain significantly underweight in small capitalization stocks, contrary to what might be expected at the beginning of an economic recovery, as we think the markets have gotten ahead of the economic fundamentals. We have maintained our investments in international stocks, particularly in Asia, as we expect the Asian economies (ex Japan) to perform better than the U.S. and the dollar to continue to be weak.
July 7, 2009
© Essential Investment Partners, LLC
Quarterly Earnings Roundup for EGP Companies
Despite a terrible economic backdrop, the companies held in the Essential Growth Portfolio(SM) did surprisingly well in their recent earnings reports. Of the forty companies that reported earnings while they were held in the Essential Growth Portfolio(SM) during the second quarter, 29 (72.5%) beat the consensus earnings estimates prevailing prior to the report.
Another seven companies (17.5%) met consensus estimates for quarterly earnings. Only four companies (10%) failed to meet estimates for quarterly earnings.
It is important to point out that analysts’ expectations have been marked down pretty significantly over the last several months. However, many of our companies faced substantial headwinds as much discretionary spending by businesses and consumers was put on hold in the first quarter of 2009. In addition, the U.S. dollar gained against many foreign currencies during the first quarter, meaning that non-U.S. sales were worth less when translated into dollars for financial reporting purposes.
Finally, the key to short term earnings success was cost-cutting. Companies slashed discretionary spending and headcount in order to bring expenses in line with lower revenues. While these reductions continue to show up in the monthly reports of job losses, the good news is that companies have become much more efficient, making it possible that earnings may recover more quickly once revenues begin to grow.
Opportunities Continue to Flow in Closed End Funds
Dislocations in the financial services sector continue to give rise to new investment opportunities in closed end funds. With all of the turmoil in the banking and investment sector over the last twelve months, we expected the opportunity set to increase. Increase it has. Whether the motivation is cost cutting, avoiding activists or simply trying to reduce the discount at which a fund is trading, fund companies have been very active in initiating corporate actions for closed end funds they manage.
Recently, we have made investments for clients in closed end funds that are liquidating, merging with “sister” open-end funds and which are making cash tender offers. Typically, we are looking to make investments at attractive discounts to net asset value and then waiting for the completion of the liquidation, merger or tender, which usually take place at or near net asset value. While these investments are not without risk of loss if events don’t turn out as expected, we view them as excellent opportunities to potentially enhance already attractive returns available on corporate and municipal bond fund investments for the fixed income portion of our clients’ portfolios.
Jerry has been following closed end funds for many, many years and has put his experience into action over the last couple of months, replacing more passive fixed income investments with these very actively managed closed end fund investments.
Avoiding Investment Frauds
News outlets have been filled with stories about investment frauds from the breathtaking to the mundane. In their rush to tell you about these frauds, rarely do our friends in the media take the time to tell you how to avoid these frauds. Learning how to avoid frauds is critical as those who don’t learn from history are doomed to repeat it.
Avoiding frauds should be awfully simple to do. No matter how well you might think you know someone, this is about the business of your money so it’s important to always ask a few very simple questions. The important thing is to ask ALL of them and if you don’t get a simple “yes” answer on any one, move on.
Here are the four questions you should ask:
(1) Is your firm registered as an investment adviser with the SEC? If yes, ask for the firm’s official name so you can look up Part I of the firm’s Form ADV on the SEC site http://www.sec.gov/investor/brokers.htm and check out the firm’s regulatory history. If the firm or any individual has regulatory problems in its past, move on. If the firm is not registered with the SEC as an investment adviser, move on.
(2) Will my investments be held by an independent custodian? Most reputable advisers do NOT take custody of their clients’ assets because of the regulatory requirements they should follow. Your adviser should use an independent bank or broker (think Schwab, Fidelity or TD Ameritrade) as the custodian for your assets. Your adviser should only be able to make trades in your account but should never be handling your money or investments directly. If the adviser wants custody of your money and investments, move on.
(3) Are you paid solely by me on the basis of assets you manage for me? If yes, the adviser is on your side of the desk – he/she owns earns more money only if you do. Any other form of compensation – commissions, payments from fund companies, incentive fees – creates of conflict of interest for the adviser which could be bad for you.
(4) Do you have a long history of managing money for clients? Look at the education and experience of the adviser’s principals that is disclosed in the Form ADV. Have they worked for reputable companies in the past? Do you they the appropriate education, experience and credentials to manage your money? If not, move on.
If you receive “yes” answers to these four questions, then you should feel comfortable in taking the next steps of evaluating the adviser’s services and fees. However, if any of the answers are “no”, you should continue your search for another adviser.
Earnings Season Better Than Expected for EGP Companies
The earnings reports for the first quarter for the companies in the Essential Growth Portfolio have so far been much better than expected. Through today, 22 of our 35 companies have reported (we have many with other than calendar quarter ends). Of those 22, 16 have beaten consensus earnings estimates, 4 have met expectations and just two have reported earnings below consensus earnings estimates.
This was a quarter in which earnings faced many headwinds – dramatically lower consumer spending, historically high job losses, capital spending reductions and dollar strengthening. However, most of the companies we own have responded very quickly with cost reductions to keep their earnings at relatively solid levels.
While these cost reductions don’t bode well for the employment picture, they do point to better earnings ahead if consumer and business spending begins to pick up and the dollar begins to weaken, allowing companies’ top lines to grow.
Partners succeeds Advisers
Effective April 1, 2009, Essential Investment Partners, LLC succeeded to the business of Essential Advisers, Inc. Essential Advisers, Inc. (100% owned by Jon Zeschin) and Jerry Paul are equal partners in Essential Investment Partners, LLC. Essential Investment Partners, LLC is registered with the Securities and Exchange Commission as an investment adviser. The registration for Essential Advisers, Inc. is being withdrawn.
Investment Outlook Overview
We believe the credit crisis of 2007-2009 and the historic events comprising it will have profound impacts on investors for at least a generation. After severely under-pricing credit risk for several years, we believe the markets will now over-price that risk for some time to come. This will create attractive investment opportunities for carefully selected fixed income investments that may provide strong risk-adjusted returns.
The proper functioning of the fixed income markets, across virtually all types of securities except Treasury securities, was severely disrupted in the credit crisis. While we don’t expect a return to the securitization craze that dominated the fixed income markets for many years, we believe that a return to a situation where “natural” buyers and sellers can be readily matched in the ordinary course of business is a pre-requisite for a sustained recovery in the financial markets.
Over the next several years, we expect consumers and businesses will “re-build their balance sheets” by saving more, reducing debt and spending less. As a result, corporate earnings growth will likely be slower and investors, stung by their 2007-2009 losses, will demand higher risk premiums for equity investments. Therefore, in the aggregate, stocks will likely be slow to recover their values, at least until the fixed income markets have regained a level footing. We believe high quality companies that can generate consistent returns on equity and earnings growth – such as those represented in the Essential Growth Portfolio℠ -- will be favored by investors.
Finally, we believe the market disruptions in 2007-2009 will present a number of interesting opportunities in closed end funds. These opportunities may arise from (1) extraordinarily wide discounts to net asset value relative to historical discount levels, (2) pending or anticipated corporate actions such as tender offers, mergers, liquidations or “open-ending”, or (3) other special situations. We may use investments in closed end funds as a substitute for other fixed income or equity investments. Because market values may change quickly, trading in these investments tends to be more active and focused on particular events. Holding periods are often short term.
We believe the unique skills and expertise of the Essential investment team are very well-suited for the investment climate we expect for the next several years and for the various vehicles we may use to protect and grow capital.
Investment Philosophy Overview
Our approach can be summed up with one word: consistency. Whether we are considering individual stocks, mutual funds, hedge funds or closed end funds, our investment process focuses on investments that are likely to deliver consistent and reliable results. We look for opportunities that may be either overlooked or under-researched and that may provide solid returns for clients over long periods of time.
For each area of investing – stocks, mutual funds, hedge funds and closed end funds – we have a well-defined discipline that describes our research process. (Each of these disciplines is defined in a separate document.) While each investment vehicle is distinct, they share a common underlying philosophy of searching for consistent results and understanding how we might lose money as much as how we might make money.
All of our investment processes are supervised by the Investment Committee, chaired by Jerry Paul. The Committee meets at least weekly to discuss the current investment and economic climate, existing client investments, new opportunities and potential changes to portfolio positioning. This process ensures that we are consistent in our approach to investing. For example, if there are new developments in the fixed income markets, we consider the impact of those developments when evaluating individual stocks.
Investment Outlook, April 2009
The roller coaster ride continues. In the first nine weeks of the year, the U.S stock market (as measured by the S&P 500 Stock Index) fell 25% and then shot up 18% before the end of the first quarter. While that rise has continued into early April and has made us all feel a little better, we are hardly out of the woods.
Three months ago, we laid out several predictions for 2009. Here’s an update on those:
“Bad economic news will continue to dominate the headlines. Job losses and the unemployment rate will continue to mount.” The unemployment rate has jumped to 8.5% and job losses so far this year are estimated at more than two million. Since the start of this recession, more than five million jobs have been lost.
“In the aggregate, corporate earnings will drop precipitously.” Trying to predict an aggregate earnings figure for the companies in the S&P 500 has become a parlor game on Wall Street. Everyone has an opinion, the dispersion among estimates is very wide and only the lucky will get it right. Even long term averages are distorted by the very high earnings of a few years ago which gave way to huge write-offs that effectively canceled out those earnings.
“The markets will continue to be highly sensitive to new government intervention.” With the stimulus package now the law of the land, AIG and the automakers are high on the minds of economic policymakers. Talk of bankruptcy for GM and Chrysler no longer spooks the market and there is growing consensus of the need to get on with it. The markets reacted positively to the Federal Reserve’s announcement of further plans to buy mortgage-backed securities and even Treasury securities. However, we are uneasy about the implications of one arm of the government issuing massive amounts of debt and another arm of the government printing money to buy the same securities.
In addition, we think it is unlikely that the Treasury Department will get a lot of private partners lining up for its PPIP (the Public-Private Investment Program to buy toxic assets from banks). First, the spread between the bid and ask prices for these securities is very high – closing the gap will not be easy. Second, the softening of mark-to-market accounting rules will make it less likely that banks will want to sell. Finally, Congress’ propensity for changing rules after the fact (think 90% tax on AIG bonuses) will make hedge fund managers very reticent to join the program in hopes of making big profits.
“The thaw in the credit markets will continue, but setbacks are likely.” Corporate bond and municipal spreads have tightened a lot over the quarter, although they are still at relatively high levels. However, defaults have been slow to appear and we expect recovery rates to be much lower than prior experience. We would not be surprised to see a few public bankruptcies back spreads up somewhat in the next few months. On the plus side, creditworthy companies are beginning to take advantage of the low rates and issue debt selectively, if it can be used to shore up their balance sheets.
“Faced with disappointing earnings and competition from bonds, stocks will have a hard time sustaining a rally.” The accuracy of this statement will be tested in the next few weeks as we get corporate earnings reports for the first quarter. After the March rally, the stock market was still down more than 10% in the first quarter. We would not be surprised to see the market retrace some of the gains of the last few weeks as the reality of the decline in corporate earnings hits home to investors.
“Government will continue to expand its role in the private sector. “ Just ask the executives at the auto makers or AIG about this statement. Perhaps the best indicator of how far we have come was not the firing of then GM CEO Rick Wagoner but rather Matt Lauer’s (NBC Today Show) question of Fritz Henderson (new GM CEO): “Sir, to put it bluntly, don’t you report to the President of the United States?”
Healthy banks, such as Goldman Sachs, are trying to convince the government to take their TARP money back. So far the government has declined. Ultimately, we expect that the government will have no choice but to pick winners and losers by taking their money back from the winners and funneling it to the losers to pay off their obligations.
“Risk management is the order of the day for client portfolios.” We have maintained a very conservative posture -- we have not rebalanced into stocks since last August. Instead, we have significantly increased bond positions in corporates or municipals, often using closed end fund special situations as attractive ways of investing in these markets. Within stock allocations, we continue to use the Essential Growth Portfolio℠ alongside mutual funds that tend to offer more downside protection. So we don’t see the need to increase the risk profile of client portfolios. Rather, we believe attractive returns can be earned by prudently taking advantage of lower risk opportunities currently available.
April 8, 2009