The first half of 2012 was a tale of two quarters. The first quarter represented the strongest start for the U.S. stock market since 1998, with Japan turning in its best first-quarter gains in 24 years. This was largely driven by a reduction of fears about Europe, as well as stronger economic data in the U.S. The second quarter gave many of those gains back. Of note in the second quarter was that markets were driven by escalating concerns about the future of the European currency union and slowing global growth, accompanied by discouraging data on employment and renewed focus on the capitalization of European and some American banks. We’ve also seen a slowdown in China and India, putting downward pressure on the prices of oil and other commodities and stocks in general. There were signs of the European situation stabilizing; after being off 7% in May, markets around the world did recover with a 4% gain in June.
Here’s a summary of global market performance in the first half of 2012, all in dollars. Of note, the global “flight to safety” over the past year has led to a stronger dollar, depressing returns outside the U.S. when denominated in the dollar.
2012 U.S. Europe Emerging mkts Global returns
Q1 +13% +11% +14% +12%
Q2 (3%) (7%) (9%) (5%)
YTD +9% +3% +4% +6%
12 mo. +5% (16%) (16%) (6%)
On the surface, investors today face a range of unattractive choices. While stocks appear fairly valued by most measures, the second quarter saw volatility well above historical norms. Holding stocks has always been risky if your time frame is short, but geopolitical uncertainty and market swings can make owning stocks feel especially dangerous today. There is considerable debate about whether stocks are expensive, cheap, or fairly valued. Some observers express doubts about the sustainability of today’s record corporate profit margins and the enduring impact of debt problems and slow growth around the world. U.S. stocks also show up on the pricey side using models such as the valuation approach advocated by Yale’s Robert Shiller, comparing stock prices to average earnings over the past 10 years, adjusted for inflation.
On the other side, a fair number of reputable analysts view stocks as historically cheap, pointing to attractive ratios of stock prices to book values and measures like multiples of earnings and cash flows. Indeed, using Shiller’s multiple of average 10-year earnings, Europe is inexpensive by historical standards. My view: for long-term investors, stocks globally today provide fair value.
Bonds pose different risks. We’re seeing historically low interest rates, as central banks around the world keep interest rates down to stoke economic growth. Given current inflation, in normal times we would expect to see interest rates about 2% higher than today, but of course these are not normal times.
And, of course, holding cash to eliminate risk from stocks and bonds virtually guarantees depreciation of purchasing power, and for many investors, cash gives them no chance of earning the returns they need to achieve their long-term goals.
Clearly, every client is different and every portfolio is different. That said, even given short-term uncertainty in stocks, I am recommending that most clients move to the upper end of the equity allocation in their risk tolerance profile. That decision is supported by perspectives from two respected investment veterans with long experience on Wall Street, Dan Fuss and Bob Farrell.
Dan Fuss: Replace market risk with company risk
Dan Fuss is vice chairman of Boston-based Loomis, Sayles & Co. With over 50 years of fixed-income experience, he is one of the most highly regarded bond managers of all time. Still actively running money in his mid-70s, Fuss manages a bond fund with over $20 billion in assets that over the past 20 years has been a top performer in its category.
In an April interview with Investment News, Fuss made an unusual recommendation for a bond manager: to sell bonds and buy stocks. The reason relates to the risk of rising interest rates. “We’re in the foothills of a gradual rise in interest rates,” he said. “Once they start to rise, you’re probably looking at a 20- or 30-year secular trend of rising interest rates.”
He went on to say that when the unemployment rate falls to between 6% and 7%, it’s likely that Ben Bernanke and the Federal Reserve Board will alter the policy that has been keeping the interest rate on the 10-year Treasury bill artificially low. “Once that happens, you need to get out of the market risk that’s in fixed income and into the company-specific risk you can find in stocks,” Fuss said.
Bob Farrell: Market rules to remember
In the 1950s, Bob Farrell attended the same masters program at Columbia as Warren Buffett, studying under Benjamin Graham, the father of value investing. In 1992 after many years in the investment business, Farrell penned 10 rules on investing. Two of those 10 are particularly pertinent today and give me encouragement about stock returns in the mid- and long-term period ahead. We always hear “this time it’s different” and it can always feel like that in the moment, but we have to try to avoid being too distracted by short term disturbing noise that would have us make decisions that are not in our best long term interest.
Rule 1: Markets return to the mean over time
“Returning to the mean” is another way of saying that over time, performance on stocks will revert to historical averages. The long-term annual return in the U.S. stock market going back to 1926 is 9.8% before inflation and 6.6% after inflation, what’s called the real return. Whenever you have an extended period in which returns exceed the long-term average, chances are a period of underperformance will follow. And the opposite applies as well; a long period of underperformance will be followed by a period of above-average returns.
The 1990s saw average real returns of 14.9% annually, the best decade on record. Then reversion to the mean kicked in, and the following 10 years saw an average annual loss after inflation of 3.4%. Add the two decades together and you get a real return that’s 1% below the long-term average. In essence, it’s taken the last decade to rectify the valuation excesses of the previous 10 years—but with that behind us, history (and Bob Farrell’s rule on reversion) suggest that long-term real returns going forward should be closer to the 6.5% average.
Rule 5: The public buys the most at the top and the least at the bottom
Since the financial crisis, total assets in U.S. fixed-income funds have more than doubled to over $2 trillion, up from $1 trillion at the start of 2008. At the same time, we’ve seen record outflows from U.S. equity funds. To me, this is further indication that, provided you have a time frame of five-plus years and can tolerate the kind of volatility we’ve seen of late, investing in a broadly diversified stock mutual fund portfolio is likely to serve you well.
Implications for your portfolio:
For retired clients, I believe in maintaining secure, liquid funds to cover two to three years of expenses. Having that buffer means that we reduce the risk of having to sell holdings at depressed levels; this also lessens the stress and anxiety for us both.
Given stock valuations and the risk in bonds, for some clients we have recently increased equity weights to the upper end of their range. Of course, market reversals from current levels are always possible; however, taking a long-term view, at current levels there is a strong case for stocks over bonds.
When building equity portfolios, I’ve always advocated strong diversification outside the U.S. This has helped my clients through most of the 2000s and hurt them in other times, such as the past year. Going forward, I have no idea whether the U.S. dollar and market will do better or worse than global markets, but I do know that we represent less than half of investing opportunities around the world and need to stay geographically diversified as a result.
Cash flow from investments continues to be a major focus for many. In an uncertain environment for immediate economic growth and equity returns, we continue to place priority on the cash yield from investments, especially for those in or nearing retirement. In my view, the returns on some REITs, investment-grade corporate bonds, the better-rated high-yield bonds and dividend stocks in selective sectors continue to make these attractive relative to many available alternatives.