April 2007: Solving For ‘X’
The Personal Portfolio Investment Equation; Are the Dependent Variables in the Risk vs. Reward Calculation Beginning to Point in a Bearish Direction?
Throughout global financial markets, investment risk is being repriced. The January Chinese stock market air pocket set a lot of investors on edge, making many aware once again that price volatility (more or less ignored these past few years) accompanies equity exposure. But, if the Shanghai market catches a cold, does that mean markets worldwide will contract pneumonia?
Americans (and U.S. portfolio managers) are relatively recent global investors. Until 2004, U.S. investor international mutual fund additions (flows) had averaged little more than $10-15 billion per year. Since 2004, this has escalated to an average of $125 billion per annum ($160 billion in 2006 alone). With increased international stock market participation comes greater shareholder interest in, and awareness of, what drives these non-dollar investment markets (today in aggregate 56% of the world’s combined stock market value of nearly $40 trillion).
The global equity market return equation is propelled by a vast array of variables including each country’s central bank monetary policy, global financial market liquidity and financial system leverage, inflation trends, currency swings, and, of course, geopolitical events. Add to this at the national level, trade, tax and immigration policies, and the potential outcomes begin to multiply exponentially. On top of this, an assessment of each country’s stock market valuation relative to alternative country market opportunities is essential. The result is a multi-variant equation defying even the highest level of computerized pattern recognition, artificial intelligence-based expert systems and/or neural network applications. As we have repeated ad nauseum, it’s back to fundamentals, judgment and assessing the probabilities. So what do the tea leaves tell us? Where do we go from here?
Past readers of these periodic letters will understand we consider predicting future investment market behavior hazardous. However, contrary to the musings today of some analysts, the fundamental underpinnings for stock markets around the world remain stable and sound. While U.S. economic growth, tempered by deteriorating residential housing conditions, is moderating, GDP growth elsewhere in free-market economies is continuing at last year’s surprisingly strong rate.
Clearly, the U.S. economic expansion, begun in 2003, is a bit long in the tooth. Corporate profit margin expansion has run its course, quarterly earnings report improvements (after nearly four years of double digit year-on-year increases) will be more subdued as 2007 unfolds. More importantly, since it represents nearly 70% of the average company’s cost structure, labor productivity improvement has begun to lag the remarkable gains of the past four or five years.
So the issue for U.S. stock market investors today becomes what one should pay for peak corporate earnings. A similar question posed in 1999, or early 2000, when the S&P 500 Index was selling at 34 times anticipated earnings, then usually elicited the reply “it’s different this time.” Of course, it turned out not to be and the P/E bubble burst in 2001 and 2002. Currently, at 15 times predicted 2007 earnings (14x EPS for 2008) valuations are at historically reasonable levels. Corporations have strong balance sheets, substantially above average levels of cash, and continue to benefit from incremental applications of new technologies.
Globally, stock market valuations relative to the U.S. are generally on the inexpensive side (e.g., Japan and Europe). Buoyed by higher natural resource prices, developing country local government fiscal circumstances are much improved. A number of interdependent bilateral and regional trade relationships among developed and developing countries have fostered more balanced economic structures, less reliant on the direction of the U.S. economy. We may be pleasantly surprised by the extent to which economic growth outside the U.S. compensates for our slowing domestic expansion.
U.S. investors tend to focus on homefront economic news, but as the global GDP balance shifts toward today’s developing countries, it is becoming increasingly important to pay attention to overseas trends. While U.S. GDP growth slows, elsewhere the expectation is relatively optimistic. At present valuations, our judgment is that stock markets around the world seem reasonably priced.
The Sub-Prime Mortgage “Meltdown” – Headline Material or Systemic Breakdown?
This month’s Bank Credit Analyst quotes the old adage that “if you want to know where tomorrow’s financial problems will be, then look at where banks are lending aggressively today.” Fueling the residential housing market boom with “creative” mortgage lending to marginal borrowers during these past five years, mortgage brokers, stock brokers and bankers have been collecting excessive placement fee income by providing financing to many who could not hope to carry the burden in a more normal interest rate environment. For a number of these so-called sub-prime borrowers, many who literally have no equity cushion in their property, teaser rate periods are ending. The moment of reckoning is at hand. Foreclosure for many sub-prime loans looms and the media has discovered the story. This saga has all the elements a content-starved media craves…lax bank regulation, predatory lending practices, the little guy disadvantaged, the unwary victimized and a serious flaw in our banking system which might end U.S. domestic economic growth.
As usual, there are elements of truth, anecdotally supported, in each assertion. However, the reality is that less than 10% of home owners have sub-prime financing and only a small sub-set of these at present are non-performing. Will the foreclosure rate rise? Possibly. Will this prove contagious, prompting other systemic consequences causing an economic headwind slowing U.S. GDP growth this year? Most likely. But unlike the S&L collapse in the early 1990’s, U.S. banks, which will have to absorb these write-offs, are in robust financial condition with ample reserves and capital to deal with the fall out. There will be headlines and pain for the players concerned, but the potential effects seem manageable within the context of a $14 trillion annual U.S. GDP backdrop. As the story continues to unfold, the steady diet of news ahead about this will probably prompt further investor risk-aversion and concern about the economic outlook. Unless accompanied by an unexpected financial market shock, a slow readjustment would not be the worst of possible outcomes. An orderly soft landing and workout over the next 12-18 months would be the expectation.
Increasing Our International Equity Weighting - Boosting Japanese Large Company Exposure to a Market-Neutral Position.
Since the late 1980’s, when the Nikkei large company stock index topped out at 38,915.87 (vs. 17,644 today), the Japanese economy and equity markets have held little attraction for foreign capital. For U.S. equity investors wishing to diversify internationally, underweighting Japan market exposure during the past 18 years has been virtually a “no-brainer.” From nearly 57% of the capitalization-weighted MSCI EAFE Index in 1989 to roughly 23% today, the painful rehabilitation of the world’s second largest economy has slowly run its course. Overshadowed by more dramatic economic developments in China and India, shackled by a banking system in need of a complete overhaul, a corporate culture wed to a stakeholder mentality, haunted by the specter of an aging population, and every effort at reform apparently blocked by a clannish political establishment, the Japanese, nevertheless, are well along the restructuring path.
Perhaps the Chinese card was a wakeup call, a competitive reality that even Japanese bureaucrats could ill afford to ignore. Until the last few years, outsiders were content to shrug off the turn-around story as primarily an unsustainable export-demand-driven (read China) phenomenon. The political capstone to all these reform efforts appears to have been Koizumi’s breaking of the postal system monopoly of pension savings. The Prime Minister’s final political act, he provided expanded freedom of investment choice giving the average Japanese citizen more options for his/her retirement savings and the country’s politicians no longer determine the allocation of private investment capital. Additionally, new securities market regulations, effective this year, remove a number of long-standing barriers to foreign corporate investment in Japanese companies, further liberalizing the country’s capital markets.
In short, after a number of false starts and apparently inconsequential incremental reforms, the sum of all these measures seems to be finally adding up to something greater than the parts. The long retrenchment appears to be producing tangible benefits, not merely a temporary response to external stimuli. Beyond this, Japanese trade policy has become more expansive. Symbiotic relationships are being explored with China and other of Japan’s natural Asian trading partners. Behind much of this the driver, of course, is the globalization of trade, information technology and travel. Having convinced ourselves of the renewed strength of the fundamental economic case, our attention turned to stock market relative valuations and currency issues. If consensus earnings projections come to pass, Japanese equity prices appear reasonable (see accompanying graphic). It seems probable also that the yen will gain at the expense of the dollar during the near term, further improving return prospects for U.S. investors in Japanese equities.
Translating this into portfolio structure will take the form of a realignment of equity holdings aimed at building up overall international emphasis through the addition of the Vanguard Pacific Stock Index Fund, a passive vehicle weighted roughly 70% in Japanese company core holdings. The international equity portion of each portfolio will include enough of this fund to bring Japanese exposure to at least a market-neutral weight. We examined the universe of Japanese/Asian actively managed mutual funds and found no compelling outstanding record when compared with the Asia/Pacific benchmark. As often is the case, the low-cost passive fund seems the optimal choice.
Other Portfolio Shifts in Emphasis
On January 12, 2007, the Board of Directors of the Numeric Small Value fund considered and approved a proposal to liquidate all shares of the fund. Despite excellent performance in their mutual funds, Numeric stated a desire to focus on their core institutional and alternative investment products as reason for redeeming their mutual fund shares. As a result, we have conducted a thorough search for a replacement manager specializing in domestic small cap value investment. Having analyzed and considered all available managers we concluded the appropriate action would be to increase the allocation to the DFA U.S. Small Value fund.
On a similar note, for those invested in the DFA Tax Managed U.S. Small Value fund, there has been a change to the fund’s name and investment mandate. The fund is now labeled DFA Tax Managed U.S. Targeted Value, reflecting the stated change in investment objective. Formerly, the fund was restricted to buying the very smallest stocks available in the market. The new stated objective loosens this restriction, and not only allows the fund to buy slightly larger stocks, but also to hold onto stocks longer as they appreciate. Despite these changes, the fund is still firmly invested in the small cap arena. Dimensional Fund Advisors felt these alterations improved their ability to manage the tax efficiency of the fund. Overall, we are comfortable with their rationale and will continue to invest in the fund.
As always, we welcome your questions, comments, and suggestions.
Sincerely,
James L. Joslin
Chairman, CEO