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Each quarter since 2008, I have posted a template for a letter to serve as a starting point for advisors looking to send clients an overview of the past 90 days and the outlook for the period ahead.
Advisors have told me that they’ve received a great response to these quarterly letters and the templates rank among my most popular articles – that’s especially the case in uncertain times such as we see today.
This quarter’s letter has four parts:
- An update on performance
- An assessment of where we are today
- Perspectives from legendary investors Dan Fuss and Bob Farrell, each with 50 years of experience on Wall Street, as well as asset allocation advice from Benjamin Graham
- Implications for investors and an outline of your recommendations for the period ahead
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Use as much or as little of the content as is appropriate for your approach. I’ve identified two portions of the letter that could be omitted to shorten it.
Just a reminder that if you’re going to use this letter, take the time to customize it and put it into your own words, so that it truly does represent your point of view. On a final note, my special thanks to Tacita Capital’s Michael Nairne for his help in crafting this letter.
The first half in review: Wisdom from three veterans of 50 years on Wall Street
As we enter July, I’m writing to provide perspective on what happened in the first half of 2012 and to share my thoughts on how to position portfolios for the period ahead. To help do that, I have tapped into three longstanding veterans of Wall Street, one who made his career in stocks, the other in bonds, and the third Warren Buffett’s teacher at Columbia who I’ve referred to in past emails.
Before we get into their views, here’s an overview of what’s happened so far this year.
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, and 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:
- 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 Europe 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 Markets |
Global Returns |
Q1 |
+13% |
+11% |
+14% |
+12% |
Q2 |
(3%) |
(7%) |
(9%) |
(5%) |
Year to Date |
+9% |
+3% |
+4% |
+6% |
12 months |
+5% |
(16%) |
(16%) |
(6%) |
Source: MSCI; Returns include dividend;, all returns in US dollars
The dilemma for investors: Dangerous stocks, unattractive bond yields
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 timeframe is short and geopolitical uncertainty and market swings make owning stocks feel especially dangerous today.
Note: To shorten this letter, you could omit the next two paragraphs (in italics):
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. US 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 Robert 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 two percent higher than today – but of course these aren’t normal times.
And of course holding cash to eliminate risk from stocks and bonds guarantees depreciation of purchasing power – and for many investors, cash gives them no chance of achieving the returns they need to achieve their long-term goals.
Clearly, every client and every portfolio is different. That said, even given short-term uncertainty in stocks, I am recommending that clients move to the upper end of the equity allocation in their investment policy. 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, the bond fund he manages has over $20 billion in assets and 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, considered the father of value investing. In 1957 Farrell joined Merrill Lynch as an analyst and stepped down as Merrill’s chief investment strategist in 1992, although he continued to provide his perspectives through articles and media interviews.
In 1992, Farrell penned 10 rules on investing. Two of those 10 are particularly pertinent today and give me encouragement about stock returns for the mid- and long-term period ahead.
If you are looking to shorten the letter, you could omit Rule 1 below in italics on reversion to the mean and just refer to the second rule. If you do that, in the last sentence above change “Two of those 10 are particularly pertinent today and give me encouragement …” to “One of those 10 is particularly pertinent today and gives me encouragement….”
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 US 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 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 US equity funds. To me, this is further indication that, provided you have a timeframe of five plus years and can tolerate the kind of volatility we’ve seen of late, investing in a broadly diversified stock portfolio is likely to serve you well.
Here’s a complete list of Bob Farrell’s 10 Market Rules to Remember.
What this means for your portfolio
In my email at the end of the first quarter, I outlined some guiding principles in my approach to building client portfolios, which I repeat here:
- For retired clients, I believe in maintaining secure, liquid funds to cover 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.
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The second principle relates to the allocation between stocks and bonds and comes from my third Wall Street veteran, Benjamin Graham, the Columbia professor I mentioned earlier under whom Bob Farrell and Warren Buffett studied. In a recently discovered 1963 talk, Graham gave this advice:
“In my nearly 50 years of experience on Wall Street, I’ve found that I know less and less about what the stock market is going to do but I know more and more about what investors ought to do … my suggestion is that the minimum amount (of the investor’s) portfolio held in common stocks should be 25% and the maximum should be 75%. Consequently the maximum amount held in bonds would be 75% and the minimum 25% … any variations should be clearly based on value considerations.”
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Third, regardless of what happens to markets in the short term, we should adhere to the agreed to investment parameters, barring a significant change in circumstances.
Some of you may recall my advice in early 2009, as we faced what appeared to be an end-of-the-world scenario and some stocks hit lows they hadn’t seen in 20 years. At that time, I urged clients to maintain a core level of equity exposure.
Given strong stock performance in the first quarter, I got questions from some clients about increasing equity weight above the maximum boundary in portfolios. And in light of concerns about Europe, recently I’ve had questions about selling stocks.
While I am always happy to discuss this on a case-by-case basis, I advise against deviating from the range that we established going into 2012. 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 the US represents less than half of investing opportunities around the world and one needs to stay geographically diversified as a result.
- The final principle relates to the role of cash flow from investments. In an uncertain environment for immediate economic growth and equity returns, we continue to place priority on the cash yield from investments. In my view, the returns on some REITs, master limited partnerships, investment grade corporate bonds, the better rated high-yield bonds and dividend stocks in selective sectors continue to make these attractive relative to the available alternatives.
Should you have questions on anything I’ve covered in this note or on any other issue, please feel free to give me or one of the members of my team a call. And as always, thank you for the opportunity to serve as your financial advisor.
conducts programs to help advisors gain and retain clients and is an award winning faculty member in the MBA program at the University of Toronto. To see more of his written and video commentaries, go to www.clientinsights.ca. Use A555A for the rep and dealer code to register for website access.
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