Second Quarter 2010 Investment Commentary
Stocks continued their slide in June, ending the first half
of 2010 with losses in every segment of the equity
market. The large-cap S&P 500 Index lost 11.8% for the
quarter, and is down 7.6% year to date. The small-cap
iShares Russell 2000 and S&P Midcap 400 indices both
lost 10% in the second quarter, though thanks to a strong
first-quarter, both benchmarks are down just above 2%
year to date. Turning abroad, the story was similarly
painful. The Vanguard Total International Stock Index
dropped 13.3% in the second quarter, bringing its yearto-date loss to 12%. The Vanguard Emerging Market
Stock Index lost over 9% for the quarter and nearly 7%
year to date.
Most of the positive news for the first six months of the
year was in fixed income. The Vanguard Total Bond
Market Index Fund, a proxy for high-quality,
intermediate-term bonds, gained 3.6% over the second
quarter, and is up 5.3% for the year through June.
Investment Outlook
As noted in the performance review above, the first six
months of 2010 have been a bit of a roller coaster—
stocks were up early in the year, then down 5% by early
February, then up almost 10% for the year by late April,
then down over 5% for the year by early June..
There is a tug of war between cyclically improving
economic and company fundamentals on the one side,
and structural concerns about debt-related stress points
and the longer-term strength of the economic recovery
on the other. The tension between these opposing forces
has left investors uncertain and the stock markets stuck
in a trading range. We think that unusually high
uncertainty could be with us for years to come because
the economic challenges we face are serious and will not
be resolved quickly.
Though we won’t forget the market freefall of 2008,
now that there has been a strong stock market rebound
from the bottom, it’s interesting to compare market
levels today to three years ago. Despite the rebound they
continue to reflect a level of economic stress:
As long-term investors, our views tend to evolve
gradually rather than change suddenly based on new
information (the fall of 2008 being a notable exception).
That’s certainly been true in recent quarters with our
assessment of the big picture unchanged. That being the
case, rather than repeat another lengthy detailed
discussion of our analysis, this quarter we’re going to
briefly recap our big-picture views, hit the key points in
our investment outlook, and close with a discussion of
how we see our job as investment managers.
The Challenges We Face
It’s no secret that there is too much debt in most of the
developed world—the United States, Europe, and Japan.
We’ve written about it ad nauseam. That the problem is
identified doesn’t lessen the challenge. In coming years
the developed world must walk a tightrope as it deals
with the pressing need to slow and ultimately reverse
debt growth without also seriously harming economic
growth rates.
The United States and other countries with excessive
household sector debt are in the early stages of what is
likely to be a long process of deleveraging. Though it is
dropping, household debt relative to income remains
excessively high. Most of these countries must also
dramatically reduce public sector (government) debt
growth and in some cases they will need to reduce the
absolute amount of debt. This huge challenge has not yet
begun. (Some countries that don’t have high private
sector debt do have huge public sector debt that must be
reduced—Japan is the most prominent example.)
While the private sector gradually delivers, and we wait
for the public sector to later do the same, at least the
United States is experiencing an economic recovery,
albeit a tepid one. There has been clear improvement
from the depths of the recession. The economic cycle is,
for now, a plus, but the big problems have not been
resolved (thus the investor tension mentioned earlier).
Several interrelated factors are the reason that the rate of
economic improvement has not been impressive in the
aftermath of such a severe recession. That leaves the
level of most economic measures still looking
lackluster—even though there is improvement.
Three variables critical to improvement in private-sector
consumption and a normal recovery—the labor markets,
credit growth, and housing—remain weak. The
weakness in these three variables is disconcerting but not
surprising to us. We have been writing about our
expectation for weakness in each for quite some time.
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We are still down about eight million jobs from the
peak and in the private sector job growth is barely
positive—though that is an improvement from last
year.
Credit market debt is contracting as it has been for
about two years, which removes an important driver
of consumer spending. We continue to believe that
consumer credit growth will be lackluster for the
foreseeable future because overall household debt
levels remain extremely high relative to income,
despite the deleveraging (debt reduction including
through defaults) that has already occurred.
Housing continues to be critical to household
financial strength and the banking sector. The
outlook remains cloudy and appears to be slipping
backward with the expiration of the homebuyer tax
credit. According to Moody’s, about 14.9 million
homeowners owe more than their home is worth.
This amounts to about one-third of all mortgage
holders. So it would not be surprising if some
housing markets saw further price declines.
The rest of the developed world looks worse. Europe is
experiencing very slow growth, southern Europe is
uncompetitive and has many countries in various stages
of sovereign debt crisis, and economic policy is a
challenge given a single monetary policy in the
Eurozone, but no political union and differing economic
situations. With the debt crisis in Greece occurring when
Europe’s recovery was already weak, the continent faces
a real risk of falling back into recession, deflation, and
longer-term, another banking crisis is possible. Japan
continues to fight deflation, has a major demographic
problem (a population skewed towards the elderly), and
has government debt higher than other developed
countries.
Fortunately, key parts of the developing world are in
much better shape with stronger balance sheets, higher
growth rates, younger populations, and slowly emerging
consumer sectors. Their strength is an important source
of support for the global recovery. And there are other
positives that help to mitigate the negatives. The
continued impact of massive federal stimulus (though
this will wane later this year in the United States),
healthy corporate balance sheets and cash flow (after
huge cuts to expenses), and a natural rebound in
economic activity after a huge decline are also sources of
strength in the U.S. and global economy.
This all nets out to a macro environment that while
improving, is still very fragile with serious intermediateterm challenges. It remains unclear whether the U.S.
recovery has a strong enough foundation to continue to
gain strength as the federal stimulus is withdrawn later
this year, the inventory rebound cycle ends, and the
debt-related stress points remain. A continued recovery
is likely but not assured and a robust recovery still seems
unlikely.
So our view of the big-picture environment we face in
the next few years is unchanged. The recovery continues
but it is not inspiring, and we see above-average macro
level risk in spite of being early in a recovery cycle. If
the recovery is sustained, which is more likely than not,
we still face big intermediate- and long-term questions
that make a wider-than-typical range of outcomes
possible. The large amount of public-sector debt
throughout most of the developed world will be a major
challenge for the global economy that will not be
resolved in the next five years. This means that it is very
possible that we will continue to face above-average
uncertainty regarding economic growth rates, inflation
rates, and interest rates not only during our five-year
horizon but in the years beyond. For these reasons, we
are sympathetic to the view (expressed by PIMCO
among others) that we may be experiencing a paradigm
shift into a difficult period that does not include the
robust economic recoveries we’ve come to enjoy after
recessions. Moreover, there could be an economic
handoff in the coming decade and beyond to the
emerging world, parts of which are characterized by
stronger balance sheets and a move towards selfsustaining growth. The rise of the emerging world
needn’t be a negative—it is not a zero sum game—but
the pain of the developed world is still likely to be
severe. If this is the case, investors will face a very
challenging environment for years to come but also one
that may at times offer significant opportunities.
Capturing Returns and Protecting Capital—Our
Investment Posture
Regardless of how good or bad the macro picture,
investment opportunities are determined by whether they
are priced attractively relative to their ability to generate
future growth and/or income. For this reason an
investment can still be attractive even if the macro
outlook is dark, or unattractive even in an extremely
positive macro environment. In fact, it is common for
investment prices to be compelling in terrible macro
environments due to investor pessimism and poor in
wonderful macro environments due to excessive
optimism.
Stocks: After a huge stock rebound from the market
depths of March 2009, our scenario analysis, in which
we assess a range of earnings growth and valuation
possibilities, continues to suggest that developed stock
markets offer low double digit return potential over the
next five years.
We often hear arguments about stocks looking very
attractive relative to low interest rates. At first glance
this seems true, and it might fuel stock market returns in
the short run. But it is important to understand that
interest rates are low because the economy is very weak.
Valuations in future years (which will influence stock
market returns over the next few years) will be impacted
by the future level of interest rates. If interest rates
remain very low three or five years from now it will
mean that the economy continues to be weak, which
would not bode well for corporate earnings growth and
would be bad for stock returns. On the other hand, if the
economy picks up, rates will surely be higher and with
risk of higher inflation there is the potential for sharply
higher rates. While moderately higher rates would not be
dangerously harmful to valuations, sharply higher rates
will make stocks less attractive versus other investments,
and would negatively impact valuations. Emergingmarkets stocks, on average, offer somewhat better
returns than developed-market stocks in all scenarios
we’ve analyzed.
Bonds: High quality investment-grade bonds such as
U.S. Treasuries and the highest quality corporate issues
offer minimal return potential over our five-year
horizon. What they do offer is a defensive investment
that could perform well if the economy is very weak or
falls back into recession. For this reason we own funds
that have some exposure to the investment-grade portion
of the bond market. But as we look out over five years,
given very low yields, returns will likely be in the low
single digits.
Typically, high-quality municipal bonds offer similar
defensive characteristics as investment-grade taxable
bonds. However, many states and municipalities
continue to suffer from the effects of a weak economy.
Their revenue from income, sales, and property taxes is,
in many cases, sharply lower than in previous years.
Most state and local governments are reducing expenses
and raising taxes to narrow the gap and most will be able
to service their debt.
In assessing the opportunities and risks in the muni
market, relative yields are an important factor offsetting
the credit quality concerns. Intermediate to longer-term
maturities tax-exempt yields are on par with and in some
cases, higher than U.S. Treasury yields. Yet the interest
is tax-free at the Federal level. This relationship is
unusual and because it makes no economic sense, it is
very unlikely to be sustained over the long run.
Moreover, with tax rates almost certainly headed higher,
increased demand for tax-free yield could drive muni-
bond prices higher in coming years. Both these factors
suggest investment-grade muni-bond prices should
eventually outperform taxable investment-grade taxable
bonds on a price basis—though this could take several
years.
There are other areas of the taxable bond market that are
more interesting than U.S. Treasuries and could be
competitive with muni bonds after taking taxes into
account such a corporate bond funds. We continue to
own Loomis Sayles Bond Fund which has flexible
mandates that allows it to seek out value wherever they
can find it. The fund is somewhat aggressive and likely
to deliver high long-term returns but at the cost of higher
short-term volatility. Overall, we are confident in our
fixed-income positions and we believe that they will
capture materially higher returns and provide much
better protection against unexpected inflation and in a
rising rate environment compared to other fixed income
investments.
Taxes: With tax rates headed higher on all types of
investment income, it will be more important than ever
in coming years to think in terms of after-tax returns for
our taxable clients. In making decisions at the asset-class
level, we consider before and after-tax returns for each
asset class. At the individual investment level, taxes can
impact a specific fund choice (for example, if we had
equal conviction in two funds, but one had a large taxloss carry forward, we’d favor it for its better tax
efficiency). Taxes also determine in which accounts we
want to own an investment in cases where clients have
both taxable and tax-exempt (e.g., IRA) accounts, and
taxes can determine when to use tax-exempt bond funds
and what allocation sizes make the most sense for certain
investments.
Conclusion
In conclusion, although there appears to be a pessimistic
feel out there, it is important to note that this will not last
forever. There will be better opportunities at some point.
We hope that some of those opportunities will come
soon and allow us to perform better than what the
broader markets give us. But we’re prepared to be
patient. In the meantime we are working hard to ensure
that when opportunities do present themselves, we are in
a position to recognize and take advantage of them,
while also being highly attuned to the potential risks in
this uncertain environment.
Mark Spielberger
Craig Brooks