March 30, 2009
Greetings,
The News Continues Depressing and Yet ...
As those around the globe who are concerned with such matters debate the future of capitalism in the U.S., and the political theater in our nation's capital unceasingly plays to a full media house, the financial markets continue to sort through the debris. The numbers are mind-numbing; $ "trn" (trillion) has replaced $ "bn" (billion) in the national budgetary debate, Federal deficits relative to annual Gross Domestic Product have moved from 2-3% of GDP to 15-20%. The global economic malaise, driven in the early part of this decade by computerized investment engineering in an age of excessive leverage, is painfully recalibrating all the variables in the investment market's valuation structure. Flooding the credit markets with liquidity, the authorities are still attempting to avoid deflation while at the same time assuring investors that inflation can be contained. It is indeed different this time; the damage has been more pervasive. And yet, although the destruction to personal balance sheets has been extensive, it is possible the U.S. equity markets (by mid-February down more than 50% from their previous peak) have nearly fully discounted the worst possible outcome.
Dr. Doom is 100% Invested in Equities! (a surprising endorsement of periodic rebalancing)
A few years back, Nouriel Roubini, New York University Professor of Finance, correctly predicted the coming credit market collapse, and just as importantly laid out how it would unfold, as well as the extent to which its devastation would materialize. At the time, he was tagged "Dr. Doom," espousing an interesting but eccentric view, often invited as a token panelist to air the negative case. Today, he is the keynote speaker at international forums and the media scrambles to present his every word. So our attention was drawn recently when, in an article in the Financial Times, Professor Roubini indicated his own pension fund was invested 100% in equities, and furthermore, it was his belief that periodic rebalancing (which he defined as "controlled market timing") was the best personal portfolio management strategy. We are reassured by his timely endorsement of what clients will recall has been our long held view and portfolio management discipline. Our feeling today is that a phased rebalancing process in client accounts where cash reserves and/or fixed income positions have become outsized relative to client account Investment Policy Statement guidelines may prove timely.
Applying the Rebalancing Discipline
In past quarterly letters and recent e-mails, we have suggested that as the equity markets appeared to be finding a new equilibrium level, a realignment back in the direction of stocks would be appropriate. The transactions (i.e., tax-loss realization programs and replacement with a few new equity fund names) in taxable accounts at last year's end began the process of a general reweighting. Currently, we have been reorganizing fixed income fund holdings, moving away from our short maturity U.S. Treasury security concentration, taking advantage of more attractive yields available in the high grade corporate and tax-exempt bond sectors, in addition to non-Treasury, Federal Agency government guaranteed bonds.
Today, the perception is that cash is king ($9 trillion currently in investor sideline reserve accounts-an amount equal to the value of the entire U.S. stock market capitalization), and debt paydown is the prevailing mode. Saving is again perceived as a virtue, skepticism rather than suspension of disbelief is the new norm. These are healthy, important new behavioral financial realities, but as the credit market paralysis heals, investor attention could once again, albeit in a more subdued manner, turn to what appear to be very reasonable values in global stock markets. Whether the recent 20+% rebound in prices will prove to be a "bear market trap," or the beginning of a significant turnaround, equity prices relative to earnings today represent acceptable value by historic measures. Keep in mind that equity markets often anticipate economic turns by as much as six to nine months (see attached exhibit from Decision Economics, Source: Standard and Poor's). Weighed in the balance between possible further equity market declines and a revival of investor market sentiment, the probabilities today would seem to favor systematic and phased realignment toward equities.
Next Steps
For the most part over the next six to twelve months, the intention is to add to current equity fund positions maintaining the proportionate balance between the domestic and international categories, and as well among value vs. growth styles and large and small companies. To this mix, we will add a new asset class position (5% of equities) in investment real estate through a diversified global Real Estate Investment Trust (REIT) fund. Although the news ahead for commercial real estate projects will continue depressing for a period of time while almost universal project refinancing problems are worked through, REIT price declines of 50-70% since last summer would seem to offer a once-in-a-generation opportunity. In the market for publicly traded REITs the worst possible outlook seems to have been fully discounted. The selection of an actively managed global REIT fund with unhedged exposure to non-dollar market properties also provides some further protection against inflation and U.S. dollar purchasing power erosion.
We will be discussing this further with you in the weeks ahead, but if in the interim you have questions, thoughts or comment, please do not hesitate to check in by e-mail or telephone at 617-210-6700.
Regards,
James L. Joslin
Chairman & CEO