By
Christopher Pavese
:
The election is over, and with it, the relentless abuse of
political advertisements and campaign bashing comes to end. So now
what? Investors woke up November 7th to a sea of red as Mr. Market
began to consider the implications of "four more years." But was
this price action a leading indicator of things to come? We think
the answer depends on your time horizon, and as such, this article
will serve to outline both our near-term market predictions (i.e.
essentially educated, but incredibly popular, guesses on short term
market direction) as well as our long-term portfolio strategy (i.e.
strategic asset allocation that drives the great majority of
portfolio returns, but puts most investors to sleep).
An Educated Guess
History would suggest that markets don't care very much about
last week's election results, at least between now and year-end. On
average, year-end rallies have been quite typical in election
years, and this one has followed the historical script remarkably
close to date. It's worth noting that gains have been even larger
in years that the incumbent party has won, and the greatest profits
during the Presidential Cycle have been realized in the three-month
period beginning in November - i.e. starting now. Apparently, who
wins is less important than the removal of uncertainty which serves
as a catalyst in and of itself.
Source: Business Insider
The
Dow Dove
over 420 points in the two days following the election, perhaps
sending a stern warning to Mr. President about the dangers of swan
diving over the fiscal cliff. We can't remember another instance
where markets were so singularly focused on a particular political
event. Well, that may be a stretch, but more importantly, this
correction in equity markets has relieved excessive optimism across
various sentiment measures and has left the market in a short-term
oversold condition, prone to rally. Granted, in addition to
well-placed cliff concerns, there have been no shortage of
horrendous earnings announcements throughout the third quarter, but
experience suggests that such a broad degree of pessimism has led
to better stock market performance ahead, provided that the bad
news is priced in and earnings season is out of the way.
From a tactical perspective, business cycles have a greater
impact on financial markets than elections. And in post-bubble
economies, business cycles tend to be shorter and milder, yet have
an even greater influence on risk assets. For now, we believe the
business cycle should continue to act as a tailwind for equities as
economists catch up to the improvement in industrial activity as
evidenced by various Economic Surprise Indices. Additionally, the
ongoing and broadening recovery in housing has provided a lift to
consumer confidence at the same time that global monetary policy
and central bank balance sheet growth provides markets with an
additional liquidity boost. The lagged effect of easy money,
illustrated in the chart below, should become more apparent in the
fourth quarter. Unfortunately, the outlook beyond the fourth
quarter and through "four more years" is not so bright.
Source: Wolfe Trahan & Co
Long Term Investment Strategy
Most investors today are stuck in a dangerous comfort zone
typified by a heavy allocation to traditional stocks and bonds.
Historically, the former has provided market participants with
exposure to economic growth, while the latter has offered a
predictable stream of income. But past performance is not
indicative of future results, and the next decade promises to
generate much slower growth and much lower income for investors.
Disciplined, focused and flexible capital allocation will be
critical in achieving long term objectives going forward. And other
things being equal, we believe a high yield is better than a low
yield in this environment, as asset classes with higher yields
often come with an embedded option on price appreciation as they
mean revert to more normal valuations. Rob Arnott, Head of Research
Affiliates, recently offered up a similar perspective, in a recent
interview:
We're drawn to higher-yielding assets not because we want
higher income but because we believe that yield is the best
predictor of future total returns. That's why our investment
process starts with the building blocks model, which estimates
long-term forward total returns from current yields and projected
growth rates. Not surprisingly, our models often emphasize
income-oriented asset classes; these sectors currently offer
spreads over Treasuries, that, when adjusted for bond quality,
are better than historical norms.
Fixed Income
Given the challenges facing the global economy today and the
elevated level of starting equity valuations, fixed income
securities serve as the foundation of our asset allocation
framework. However, unlike most yield-starved traditional fixed
income assets, the great majority of our exposure is invested in
structured credit and mortgage-related securities with an average
yield of 7.2% today. Examples include DoubleLine Opportunistic
Credit (
DBL
) and PIMCO Dynamic Income Fund (
PDI
). Our attraction to the asset class is predicated on the
increasingly obvious recovery in residential real estate. Home
prices are rising alongside record affordability, while
delinquencies are dropping and new households are now forming
faster than homes are being built. The current stabilization in the
domestic housing market is also consistent with the historical
experience of dozens of major housing busts across OECD countries
in terms of average duration and average decline in real home
prices.
We believe the best way to capitalize on an improvement in
domestic housing is through the structured credit markets, which
have not yet reflected the recovery in underlying asset prices.
While the distressed phase of this market move is clearly behind
us, we anticipate that the pending demand from an institutional
shift into higher yielding assets will overwhelm the shrinking
supply of this self-liquidating market. As a good friend recently
reminded me, the last six to twelve months of a trend are often the
most rewarding. We think the attractive yields on offer in the
non-agency market, shown below, are likely to be front-end loaded,
resulting in significantly greater IRRs for investors, compliments
of Chairman Bernanke. Put simply, we are being paid a healthy
annual cash flow of 7.2% on our investment, which comes with an
embedded option on higher housing prices. Healthy cash on cash
returns combined with strong technicals provide us with plenty of
downside protection.
Broad Opportunity Set Outside of Government
Bonds
Source: PIMCO
Natural Resources
Since the range of potential outcomes in a deleveraging process
can be extraordinarily wide, we believe the optimal portfolio
should maintain a barbell approach to hedging both inflation and
deflation risks. At one end, we believe that the cash flow produced
by a heavy allocation to income generating assets provides us with
a degree of principal protection and a smooth stream of returns in
the event that the pace of deleveraging accelerates. At the same
time, we recommend a healthy allocation to real assets to hedge the
right tale of the risk distribution.
Most investors have no memory of owning gold, nor do they feel
the need to do so today. As one of our external managers recently
reminded us:
Gold is durable, rare, difficult to mine, very limited in
supply growth, and is the only substance which has served as
money and a store of value for thousands of years; in fact, it
backed the US money supply until the early 1970.
Considering the lack of true "safe havens" around the globe, the
coordinated money printing programs of central banks, and the
potential for a
Developed World Balance Sheet Apocalypse
, we think it is reasonable to at least consider the possibility
that the money supply is fully backed by gold once again. Such an
occurrence would not be unprecedented, as the gold coverage ratio
has risen above 100% twice during the past century. Were this to
happen today, the value of an ounce of gold would exceed
$12,000.
Source: Guggenheim Securities, LLC
Accordingly, we think precious metals have a place in every
investor's portfolio. Today, gold and gold mining equities
represent the majority of our exposure to natural resources. The
balance is invested across a basket of MLPs via Alerian's MLP ETF (
AMLP
), which yields a healthy 6% today and provides the portfolio with
a natural inflation hedge. We outlined our logic for
Investing In Infrastructure
in a recent
Broyhill Letter
.
Global Equities
When measured in terms of the experience set of portfolio
managers in the industry today, the current investment landscape
and macroeconomic uncertainty is unprecedented. Yet, despite these
glaringly obvious risks, equity market valuations have only been
higher than current levels 20% of the time since 1926. At 22.2
times trailing ten-year earnings, today's Cyclically Adjusted PE is
very high in historic terms. So while a case can be made for fresh
near-term highs in equity markets investors should be aware that
such a tactical call amounts to a speculative bet on yet higher
prices, rather than a long-term fundamental investment derived on
the basis of cash flow. Since our business is one of investment
rather than speculation, equities represent a rather small
allocation across our portfolios today. Importantly, this is not a
decision based on a dire economic outlook. Rather, it is a
systematic, value-driven approach to asset allocation that alters
our asset mix based on the opportunity set offered by Mr. Market.
Expected stock returns are just too low today to justify a rigid
adherence to a static portfolio mix, dominated by equities.
Source: AQR Capital Management, LLC
As illustrated by the table below, long-term expected returns
fall dramatically as the starting level of valuation increases.
More specifically, US equity market valuations today imply that
real stock market returns over the next decade will not break 1%
annually. Relative to the yields on offer in the
mortgage-securities market or the upside potential in precious
metals, the returns on offer across domestic stock markets are not
particularly exciting.
.
Source: AQR Capital Management, LLC
We have, however, begun putting some dry powder to work in
global equity markets over the past quarter, as evidenced by a
dwindling cash balance. There is no question that the outlook for
the global economy remains extremely challenging, as shortened
business cycles are more susceptible to periodic bouts of
recession. At the same time, European economies can only hope for
such "periodic" bouts of recession, given that consensus
expectations today are moving closer to the Japanification of the
EU. That being said, it is important to remember that the actual
risk of permanent impairment is usually lowest when perceived risk
is highest and as such, it is likely that the market has already
discounted the impact of a prolonged European recession. The news
only needs to be slightly less bad for stocks to rise from today's
extremely depressed valuations and it would seem that ECB President
Mario Monti's recent actions have provided markets with such a
catalyst. As we concluded in
Q3-11's Broyhill Letter
:
It would be foolish to doubt central banks' capacity to print
money to "paper over" mountains of bad bank and sovereign debt.
History suggests that all governments ultimately go down this
road after exhausting austerity. The only question is how bad
things get before they act. We suggest it is simply a matter of
time before "Helicopter Mario" chooses the seemingly lesser of
two evils.
It would seem that "Helicopter Mario" has since made his choice.
As a result, a disorderly destruction of the monetary union would
appear to be off the table (for now), removing a significant risk
from the market. European equities may not have hit bottom yet, but
valuations suggest we are getting close. Among the world's major
stock markets, Europe is the cheapest, based on current dividend
yields. It is also cheapest on cash flow yield, book value yield
and earnings yield. A cheap asset can easily get cheaper.
Unfortunately, we've learned this lesson the hard way. But we've
also learned that unlike buying an overpriced stock which offers
roughly zero chance of ever returning to previous valuation
heights, investing in a heavily discounted asset can beget
temporary losses, but ultimately results in much higher long-term
compounded returns.
Buying early is the notorious curse of the value investor.
However, buying stocks when they trade at low multiples has
historically been a rewarding strategy. Ned Davis Research reports
that when the Cyclically Adjusted PE on European equity indices has
been below 13.5, European stocks delivered annualized returns of
16.2% over the following five years. These markets currently trade
at a Cyclically Adjusted PE of 12.2 - a multi-decade low.
Source: Morgan Stanley
Bottom Line
Unless you are analyzing micro caps, like our talented friends
at
Privet
in Atlanta, the only information edge available in the market today
is inside information, and unless you are plugged directly into the
CBOE and measuring your success in nanoseconds, trading edges are
just as hard to come by. So by default, we tend to side with our
friends at
Virgo Investment Societas
who postulate that:
time arbitrage is the most obvious structural opportunity to
add value in the current market environment.
This means committing capital to undervalued and overlooked
assets with significant upside potential on a three to five year
horizon, while most investors continue to struggle looking past the
next quarter. We've found that an emphasis on current cash flow can
minimize market volatility while we are "paid to wait" for price to
align with value. Today, the result is a portfolio heavily invested
in mortgage securities yielding 7.2% on a loss-adjusted basis and
short duration credit instruments yielding 5.5% with minimal
interest rate risk, like PIMCO 0-5 Year High Yield Bond Index (
HYS
).
Our portfolios maintain a healthy allocation to natural
resources, comprised of precious metals and infrastructure assets
yielding 6.0% with growing distributions. And finally, while
opportunities are increasingly limited in domestic equity markets,
we believe recent investments in global equities, with a 5.5%
average dividend yield, provide an attractive balance of current
cash flow and a cheap option on future price appreciation. Specific
examples, and current holdings include Vanguard's MSCI Europe ETF (
VGK
), SPDR's Euro STOXX 50 (FEZ) and WisdomTree's International
Dividend Fund Ex-Financials (DOO).
We look forward to sharing some of the specifics of our European
equity investments with you in the near future.
Disclosure:
I am long [[DBL]], [[PDI]], [[HYS]], [[AMLP]], [[VGK]], [[FEZ]],
and [[DOO]] but positions may change at any time.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
See also
UPS - An Old 'Dog' That Can Still Jump
on seekingalpha.com