I received a call from a Dow Jones newspaper reporter yesterday asking me my thoughts on laddered bond portfolios as a strategy for income in retirement. She was under the impression that I was not in favor of them - possibly from something I'd written in the past (although she wasn't able to quite recall what she'd read and I wasn't able to quite recall what I might have written). Anyway, we had a very pleasant half hour conversation about laddered portfolios, fee-only versus fee-based (brokers) advisors, variable annuities, and properly diversified multi-asset portfolios...among other investment topics.
But I thought I ought to pass on my thoughts on laddered bond portfolios to my readers, since it was the primary reason she called.
I think a laddered bond strategy makes quite a bit of sense for retirees, but only as a part of a properly diversified multi-asset portfolio. I am not in favor of single asset portfolios for anyone, let alone a retiree. Putting your eggs all in one basket is never a good idea, even if it is in the supposedly safe basket of Treasury bonds, which I personally believe carry quite a bit of risk currently. (Bill Gross of Pimco is on the same page by the way as his firm - the largest bond investor in the world - is currently completely out of Treasury bonds according to statements the bond king has made in recent months).
Bonds were known as certificates of confiscation back in the early 1980s, before the great bond bull market kicked off in 1982. Bond investors had lost their shirts over the prior 15 years or so as interest rates had risen steadily along with inflation. Negative real rates eroded bond wealth steadily for better than a decade. However, Paul Volcker's Federal Reserve changed all of that by committing to sound monetary policy designed to bring down inflation and restore the stability of the dollar as a store of value. Bonds have proven a splendid investment ever since... until now.
It is highly likely that inflation will continue to rise and, with it, interest rates over the next decade. We may have another year or two to wait before the trend really gathers steam, but without drastic changes in U.S. monetary and fiscal policy, the odds of a long bond bear market are high. A laddered dollar bond portfolio is not where you want all of your assets in such an environment. Yes bonds will mature yearly and can be reinvested at higher rates, but the bonds in you portfolio will lose value. Any sales necessitated by unexpected cash needs will result in losses. And generating capital losses in bond investing is a cardinal sin. Even more dangerous is the strategy of attempting to "ladder" a bond mutual fund portfolio, given that bond mutual funds have a perpetual duration - duration is a measure of bond price sensitivity to changes in interest rates. The longer the duration the bigger the price moves in a bond, and perpetual is as long as you can get.
Far better to build a properly diversified multi-asset portfolio for our retiree that might include a laddered bond portfolio to go with the high-quality dividend paying blue chip stocks, the dollar diversifying international assets, and the inflation hedging tangible assets (real estate and commodities primarily).
The S&P 500 is rallying short term after moving into oversold territory, but is likely to at least retest the recent low at 1256. It is still too early to tell if the correction is merely the pause that refreshes on the start of a topping process that will ultimately lead to the next downleg in the ongoing secular bear market. We reiterate that fair value for the S&P 500 is in the 900 area and that the economy is now showing clear signs of slowing - a combination that would suggest prudence is the better part of valor at the moment.
Wednesday, June 22, 2011
Monday, June 13, 2011
Correction
The market is finally starting a correction that could eventually turn into a full fledged bear market, depending on what policy decisions the administration, the Federal Reserve, the ECB, and the Chinese make in response to a slowing economy in the U.S. and rising inflation overseas. The S&P 500 has lost 7.7% since its 2 May peak of 1370.58 (5.3% of that loss coming in June). The next key support is 1249 - the 16 March low. Selling pressures sufficient to take out the 1249 support level would sharply increase the likely of further significant downside testing. There is strong support for the S&P 500 from 1150 down to 1000 however, making the onset of a full blown bear market unlikely in the next few quarters. Tops take time to form and it is more likely that a bounce off of 1249, or perhaps off of 1220 support (10.9% pullback) will see the S&P 500 rally into year end and finish somewhere near the May 2 high of 1370.
Nevertheless, a renewal of the secular bear market this year can't be ruled out. S&P 500 fair value is in the 900 area, net profit margins are at record levels (and will certainly fall going forward), and the U.S. economy is showing signs of slowing. As well, the Chinese are tightening monetary policy and the ECB is talking about tightening monetary policy - both entities would like to deflect inflation away from their shores.
On the other side of the ledger is the President's desire to win re-election. It is very likely that Obama will take steps to bolster the economy short term (and by extension the stock market) in order to win re-election. No post WWII incumbent has won re-election with unemployment above 7.2%, which means Obama must do something fairly quickly to light a fire under the jobs market if he hopes to serve a second term.
Likewise, Ben Bernanke continues to send signals that QE2 will not be the end of his monetary largess. He apparently remains determined to use every monetary policy tool in his tool box to keep the stock market afloat while the banks continue to repair their shattered balance sheets. Bernanke is likely to trot out another initiative immediately on the heels of QE2's end on 30 June. Our forecast is still for a resumption of the bear market sometime in the next 12 to 18 months, but we continue to believe that we are more likely to feel the Bear's bite in 2012 than 2011.
We continue to look for high-quality dividend paying blue chips to buy. We also continue to invest in shorter duration fixed income investments, given the likelihood of rising interest rates in coming years. Finally we continue to invest in nondollar assets that will provide a hedge against purchasing power loss as the shortsighted policies pursued by politicians (on both sides of the aisle) and the Federal Reserve all but ensure rising inflation over the next decade.
Nevertheless, a renewal of the secular bear market this year can't be ruled out. S&P 500 fair value is in the 900 area, net profit margins are at record levels (and will certainly fall going forward), and the U.S. economy is showing signs of slowing. As well, the Chinese are tightening monetary policy and the ECB is talking about tightening monetary policy - both entities would like to deflect inflation away from their shores.
On the other side of the ledger is the President's desire to win re-election. It is very likely that Obama will take steps to bolster the economy short term (and by extension the stock market) in order to win re-election. No post WWII incumbent has won re-election with unemployment above 7.2%, which means Obama must do something fairly quickly to light a fire under the jobs market if he hopes to serve a second term.
Likewise, Ben Bernanke continues to send signals that QE2 will not be the end of his monetary largess. He apparently remains determined to use every monetary policy tool in his tool box to keep the stock market afloat while the banks continue to repair their shattered balance sheets. Bernanke is likely to trot out another initiative immediately on the heels of QE2's end on 30 June. Our forecast is still for a resumption of the bear market sometime in the next 12 to 18 months, but we continue to believe that we are more likely to feel the Bear's bite in 2012 than 2011.
We continue to look for high-quality dividend paying blue chips to buy. We also continue to invest in shorter duration fixed income investments, given the likelihood of rising interest rates in coming years. Finally we continue to invest in nondollar assets that will provide a hedge against purchasing power loss as the shortsighted policies pursued by politicians (on both sides of the aisle) and the Federal Reserve all but ensure rising inflation over the next decade.
Friday, May 27, 2011
Stocks For The Long Run?
There are at least a few academics who argue that stocks are too risky for retirement portfolios and that an all bond portfolio is more appropriate for retirement portfolios, given the much more predictable return streams of bonds versus stocks. Bond portfolios can be constructed to ensure that cash flows match known cash needs throughout a retirement plan. Unfortunately, bonds are not particularly good at preserving purchasing power when inflation unexpectedly makes an appearance (Biechele Royce is forecasting rising inflation over the next 10 plus years). Stocks, then, are a necessary evil for investors who fail to save enough during their accumulation years - the vast majority - to make it possible to survive in retirement on an all bond portfolio.
Okay, okay time out.... You are puzzled because I'm dissing stocks for the long run aren't you? I mean, the baby boomers grew up in the stock friendly world of the 1980s and 1990s. We were told that stocks always deliver a superior return over the long run and that most of us should just forget about bonds and pile into stocks as long as we were looking at a 10-year plus time horizon. We were told that we'd end up with far more wealth in retirement by sticking with the superior long run returns of stocks. Well.... we weren't really getting the whole story when it comes to stock returns versus bond returns as it turns out.
The fact is that bonds have far outperformed stocks over the last 10 years, to the tune of 5.23% per annum, and have kept up with stocks over the last 20 and 30 year periods with far less volatility. The fact is that investors over the last 30 years would've been far better off sticking with bonds ONLY. But that must be a very unusual occurrence right? Not really. It turns out that there have been a number of very long periods during which bonds were superior to stocks. The period 1803-1857 comes to mind - bonds trounced stocks handily and it wasn't until 1871 that stock investors managed to break even. Stocks failed to match bonds once again from 1929 -1949 and stocks didn't manage to break even until the early 1960s. We've had a huge bull market in bonds since 1982 and it may not be quite over yet.
But it is probably coming to an end, given that nominal interest rates aren't likely to fall much further absence outright deflation - something that Federal Reserve Chairman Ben Bernanke says isn't possible if a central bank is willing to keep printing money, as ours clearly is. So back to stocks for the long run then? We don't think so given the tremendous over valuation that currently exists. It is hard to get excited about loading up on stocks when they are trading some 45% above fair value.
And that leaves us with a conundrum - neither stocks nor bonds are particularly attractive for the long run right now, making it a difficult time to be an investor. I am holding cash and gold stocks personally, along with a position in a single stock. I have a list of companies I intend to buy when the next big sell off hits, likely sometime in the next 12-18 months.
Biechele Royce Advisors builds properly diversified portfolios (mine is not) and is currently overweighting nondollar assets, tangible assets, and big blue chip dividending paying U.S. companies. We continue to buy good companies at great prices as we find them.
Okay, okay time out.... You are puzzled because I'm dissing stocks for the long run aren't you? I mean, the baby boomers grew up in the stock friendly world of the 1980s and 1990s. We were told that stocks always deliver a superior return over the long run and that most of us should just forget about bonds and pile into stocks as long as we were looking at a 10-year plus time horizon. We were told that we'd end up with far more wealth in retirement by sticking with the superior long run returns of stocks. Well.... we weren't really getting the whole story when it comes to stock returns versus bond returns as it turns out.
The fact is that bonds have far outperformed stocks over the last 10 years, to the tune of 5.23% per annum, and have kept up with stocks over the last 20 and 30 year periods with far less volatility. The fact is that investors over the last 30 years would've been far better off sticking with bonds ONLY. But that must be a very unusual occurrence right? Not really. It turns out that there have been a number of very long periods during which bonds were superior to stocks. The period 1803-1857 comes to mind - bonds trounced stocks handily and it wasn't until 1871 that stock investors managed to break even. Stocks failed to match bonds once again from 1929 -1949 and stocks didn't manage to break even until the early 1960s. We've had a huge bull market in bonds since 1982 and it may not be quite over yet.
But it is probably coming to an end, given that nominal interest rates aren't likely to fall much further absence outright deflation - something that Federal Reserve Chairman Ben Bernanke says isn't possible if a central bank is willing to keep printing money, as ours clearly is. So back to stocks for the long run then? We don't think so given the tremendous over valuation that currently exists. It is hard to get excited about loading up on stocks when they are trading some 45% above fair value.
And that leaves us with a conundrum - neither stocks nor bonds are particularly attractive for the long run right now, making it a difficult time to be an investor. I am holding cash and gold stocks personally, along with a position in a single stock. I have a list of companies I intend to buy when the next big sell off hits, likely sometime in the next 12-18 months.
Biechele Royce Advisors builds properly diversified portfolios (mine is not) and is currently overweighting nondollar assets, tangible assets, and big blue chip dividending paying U.S. companies. We continue to buy good companies at great prices as we find them.
Monday, May 16, 2011
Presidential Cycle
The S&P 500 sold off two weeks ago, losing 1.72%. Energy was the hardest hit, declining close to 7%, followed by materials, which was down 3.77%. Defensive sectors such as Staples and Telecom were flat or only down slightly. The overall market traded basically flat last week until a Friday sell off closed it out near its recent lows.
So much for the very short term action. Longer term the S&P 500 is trading 45% above fair value, according to Jeremy Grantham of GMO ($108 billion under management), who pegs fair value at 920 for the S&P 500. Grantham’s estimate of fair value gibes with both Tobin’s Q and Shiller’s P/E (very good long term measures of stock market fair value). All of which means equity investors are still playing with fire. Hide out in bonds? Not Treasury bonds, at least not according to Bill Gross of Pimco fame. Bill has informed the world that Pimco has sold all of its Treasury holdings ahead of the end of QE2 (set to finish up at the end of June).
Grantham had thought that the combination of QE2 and the third year of the presidential cycle could push the S&P 500 back to between 1400 and 1600 by October of this year – putting it back into bubble territory. (Grantham is a student of bubbles in various asset classes throughout history and measures them against average valuations. He uses a two standard deviation divergence from long-term fair value to mark a bubble – what is supposed to be a once in 44 year event). Grantham now thinks it much less likely that the S&P 500 will reach the 1400-1600 level by fall, given its failure to advance farther by now. Historically, the market has advance 20% in the first seven months of the third year of the Presidential cycle (started last October). The entire return, on average, for the 48 month cycle is only 21%, meaning investors can expect a whopping 1% return from the S&P 500 over the next 41 months based solely on the Presidential cycle. Of course, these are only averages for the Presidential cycle and don’t take into account things like the current overvalued state of the market or the current jobless recovery (negatives for likely future returns.)
Bottom line for investors (and yep I know I’m starting to sound like a broken record) is that the market remains very overpriced and a dangerous place to be right now. Healthy levels of cash will ensure that any 20% to 30% decline from current levels in the next few years will make it possible to buy cheap assets that will provide above market rates of return going forward.
Biechele Royce Advisors continues to buy good companies at great prices as we find them. We are holding extra cash in clients’ portfolios for the inevitable rainy day that is coming, likely in the next 12 to 24 months.
So much for the very short term action. Longer term the S&P 500 is trading 45% above fair value, according to Jeremy Grantham of GMO ($108 billion under management), who pegs fair value at 920 for the S&P 500. Grantham’s estimate of fair value gibes with both Tobin’s Q and Shiller’s P/E (very good long term measures of stock market fair value). All of which means equity investors are still playing with fire. Hide out in bonds? Not Treasury bonds, at least not according to Bill Gross of Pimco fame. Bill has informed the world that Pimco has sold all of its Treasury holdings ahead of the end of QE2 (set to finish up at the end of June).
Grantham had thought that the combination of QE2 and the third year of the presidential cycle could push the S&P 500 back to between 1400 and 1600 by October of this year – putting it back into bubble territory. (Grantham is a student of bubbles in various asset classes throughout history and measures them against average valuations. He uses a two standard deviation divergence from long-term fair value to mark a bubble – what is supposed to be a once in 44 year event). Grantham now thinks it much less likely that the S&P 500 will reach the 1400-1600 level by fall, given its failure to advance farther by now. Historically, the market has advance 20% in the first seven months of the third year of the Presidential cycle (started last October). The entire return, on average, for the 48 month cycle is only 21%, meaning investors can expect a whopping 1% return from the S&P 500 over the next 41 months based solely on the Presidential cycle. Of course, these are only averages for the Presidential cycle and don’t take into account things like the current overvalued state of the market or the current jobless recovery (negatives for likely future returns.)
Bottom line for investors (and yep I know I’m starting to sound like a broken record) is that the market remains very overpriced and a dangerous place to be right now. Healthy levels of cash will ensure that any 20% to 30% decline from current levels in the next few years will make it possible to buy cheap assets that will provide above market rates of return going forward.
Biechele Royce Advisors continues to buy good companies at great prices as we find them. We are holding extra cash in clients’ portfolios for the inevitable rainy day that is coming, likely in the next 12 to 24 months.
Tuesday, April 12, 2011
Real Asset Allocation
"The market tends to be priced in a way that if you want to try to outperform, you have to take the risk of looking like an idiot," according to Ben Inker, the head of asset allocation at Boston-based global money manager Grantham, Mayo, van Otterloo & Co. (GMO has approximately $107 billion under management). And looking like an idiot can get you fired in the money management business, which means the markets are not efficient, since money manager behavior is predictable. Career risk is real and money managers do make decisions to avoid taking on career risk. It is far better to lose money together than make money alone. Likewise, it is important to stay up with the Jones when the market is rising. Falling behind the pack in a bull market can get you fired as well. Mutual funds are currently fully invested, with cash levels back to the 2007 lows. Its a curious decision mutual fund managers have made to go "all in" right now given the demonstrably overvalued market and the obvious catalysts for a correction/bear market, unless you understand that it is career risk that is driving the train, not investment risk. Inker's quote bears repeating because it is the alpha and omega of money manager behavior. "The market tends to be priced in a way that if you want to try to outperform, you have to take a risk of looking like and idiot." Inker goes on to explain that to outperform you have to deviate from your benchmark, and that increases the risk of under performance and, in the extreme, looking like and idiot and getting fired. It is no coincidence that fully 75% of the so-called actively managed funds are actually closet indexers according to academics (closet indexers claim to actively manage their funds but actually mimic their benchmark, leaving investors to pay high fees for something they could get for a fraction of the cost by simply investing in index funds). And what is the impact on the market as a result of the career-risk factor? Markets exhibit herd-like behavior, which leads to momentum, and money flowing into whatever strategy is doing best, according to Inker. Valuations rise to extremes within the better performing asset classes and sectors until the gravitational pull of replacement cost exerts itself. Replacement cost (Tobin's Q is a very good long term measure of the relationship between the market and replacement cost) eventually always brings the market back to fair value, but typically with an overshoot to the downside first (as the herd exits in mass, ignoring valuations on the way down just as it did on the way up). Biechele Royce Advisor (like GMO) increases allocations to assets and sectors AFTER they have dropped and decreases allocations to assets and sectors AFTER they have risen, in order to take advantage of a HUGE inefficiency in the markets created by career risk. However, we primarily let individual securities lead us to our over and under weights, using big picture considerations to provide a context for our valuation decisions. In other words, rather than making a broad call on an asset class, we instead do basic business valuation in order to buy good companies at great prices. Likewise we let basic business valuation drive our sell decision, making sure we exit a position once the company has returned to fair value.
Friday, March 25, 2011
Variable Annuities - the New Snake Oil
The cliche of the snake oil salesman is deeply embedded in American cultural in the form of frequent depictions in the movies of those fast talking salesmen touting their wares to a crowd of curious onlookers. Most of you probably have seen a scene from a western in which the smooth talking dandy pitches his wonderful elixir as "good for whatever ails you!" Variable annuities with a guaranteed minimum wealth benefit (GMWB) are increasingly sold in much the same manner. Insurance agents and fee-based "advisors" increasingly push variable annuities on anyone and everyone, regardless of their age, income, and wealth. Frequently these salesmen don't even understand what they are selling, only that they get BIG commissions for selling them. Are you a 78 year-old single woman with Alzheimer, but with $1.3 million in the bank? No problem! You NEED a variable annuity with a GMWB rider. A couple in your mid-60s with two defined benefit plans between you? No problem! You need TWO variable annuities and you definitely need to replace the ones you were already sold in your Roth IRAs with two brand new ones that are waaaaay better! Why are they better? Because they are NEW and generate another commission for ME! The truth is that variable annuities are one of the most oversold products out there because of their big commissions, not because of their actual performance. Now here's a dose of reality courtesy of Dr. Michael Edesess (advanced mathematics and economics), Louis Mittel of Advisor Perspectives, and Robert Huebscher. Variable annuities under perform a passively managed fixed income portfolio by almost 1.60% annually on average based on modeling 100,000 trials using random date-of-death Monte Carlo simulations. In fact, a passive fixed income strategy has a higher internal rate of return (IRR) for all life spans through 113 years of age. The variable annuity returns just can't make up for their higher fees and the cost of the longevity insurance embedded in the product over shorter periods of time. Of course, insurance industry sponsored research "shows" that variable annuities are superior to passively managed fixed income portfolios. However insurance industry studies are flawed to say the least. For instance, industry studies assume that an investor will live to be 90 years of age 100 percent of the time even though the actual probability is only 19%. As well, insurance industry studies "show" that variable annuity income will keep pace with inflation even though inflation has averaged 3% over the last century and the actual nominal median average income increase for variable annuities is only 0.5% per year (far below insurance industry claims). So the next time the snake oil salesman comes a calling, "JUST SAY NO!" Biechele Royce Advisors could sell you variable annuities and make those big commissions, but instead chooses to do the right thing by building you properly diversified stock and bond (fixed income) portfolios to help you achieve a successful retirement. Best Regards, Chris Christopher Royce Norwood, CFA Biechele Royce Advisors, Inc.
Tuesday, March 15, 2011
Valuations Matter
The table below summarizes very nicely why we continue to view the U.S. stock market as high risk and low return. We have been projecting since the beginning of the year that a 10% to 20% pullback was likely sometime in the first two quarters of 2010 . We think the events in Japan are now serving as a catalyst and believe the correction has begun. The S&P 500 is down 6.2% peak to trough currently and we expect it to fall to at least 1200 before the current pullback is over. A correction to the 200-day moving average would result in a decline of about 12% and is the minimum we expect at the moment. A deeper correction back to 1100 is certainly possible. Biechele Royce will continue to buy good companies at great prices as they come available.
TABLE
10-year S&P 500 total returns by P/E level
***Shiller P/E is currently 24***
Shiller Avg Annual Return
Below 12 16.0%
12 to 16 14.3%
16 to 20 10.3%
20 to 24 6.6%
Above 24 3.5%
5-year S&P 500 total returns by P/E level
***Shiller P/E is currently 24***
Shiller Avg Annual Return
Below 12 16.5%
12 to 16 12.4%
16 to 20 9.3%
20 to 24 11.6%
Above 24 3.2%
(Note the jump in five-year returns for valuations in the 20 to 24 range: it is the result of short-term momentum in bubble markets. The S&P 500 hasn't seen Shiller P/Es at or above 24 except for a very brief period in 1929, and then during the current bubble years encompassing 1999 to the present.)
Please feel free to call or e-mail with questions about the current investing environment...
Regards,
Christopher Royce Norwood, CFA
Biechele Royce Advisors, Inc.
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