By
William Smead
:
A tremendous amount of energy and effort has been expended in
the US on behalf of wealthy investors to secure returns while
reducing risk. Like any useful endeavor, it started out as a wise
thing and reached its stride in the late 1990s as a way to deal
with a massive asset misallocation. As Warren Buffett always says,
"What the wise man does at the beginning, the fool does at the
end". It appears to us that the efforts to eliminate risk in the US
capital markets have reached the "foolish" point.
We at Smead Capital Management believe this, because everyone
learns in their first economics class that competition from new
suppliers causes marginal profits to move to zero. We observe
almost all the wealth managers in the marketplace practicing risk
reduction strategies in wide-asset allocation models. Therefore, we
have three questions to answer for you today. What happened in the
last 30 years to lay the groundwork for today's circumstance? Why
has the profit disappeared for those who seek to reduce risk? Is
this an unusually favorable time to take risk in the US?
I came into the investment business in 1980. Decades of
inflation and miserable returns from bond investments had driven
interest rates to sky-high levels (20% prime/15% Ten-year
Treasuries). A pair of crippling recessions in 1980-82 broke the
back of inflation. The bond market took until 1993 to fully adapt
to a more moderate inflationary environment, and "wise" investors
feasted on double-digit returns in their interest-bearing
instruments. When the money market funds hit 3% and long-term
Treasury bonds dropped near 5% in 1993, investors had to move
elsewhere to seek double-digit returns. As bond and interest
bearing securities matured between 1993 and 1999, wealth advisors
helped investors pursue high returns in US equities. This
phenomenon was based in large-cap growth stocks and was led by the
technology sector. By 1999, individual and institutional investors
had left the bond market for dead.
The concentration and misallocation of capital in the largest US
large-cap stocks was legendary. The S&P 500 index peaked with
around 37% of its capitalization in tech and telecom stocks in
early 2000. The Federal Reserve Board's Z-1 1999 year-end report
showed that common stock ownership dwarfed household ownership of
bonds and other interest bearing instruments like CDs and money
market funds. Almost every other asset class was starved for
capital, as investors sought to be pioneers by investing in ways to
make money from "the internet changing our lives".
Twelve years have passed, including two 40%-plus bear market
declines in US large-cap stock indexes. The first one decimated
tech investors and the second one decimated everyone else,
precipitating a mass scramble to reduce risk. Ironically, those who
anticipated these circumstances enjoyed outsized returns in the
asset classes (emerging market equity and debt, gold, oil and other
commodities, junk bonds, etc.) which were starved for capital in
1999. In other words, diversifying them into reduced risk and
raised returns. We've called this asset allocation "Nirvana".
As wealth managers around the country witnessed asset allocation
models spitting out above-average returns by being widely
diversified, they quickly moved in to get their share of these high
profit margins. We estimate that by the summer of 2011, such a
large crowd of wealth advisors and institutional investors had
populated the wide asset allocation space that marginal profits
were approaching zero. Too many animals were feeding at the same
trough or grazing from the same fields. It appears that the same
thing is happening in the alternative investment space, where hedge
fund results found only 13% of managers beating the S&P 500
Index in the first nine months of 2012.
In a very effective video interview at Morningstar.com,
Christine Benz interviewed Bill Bernstein, a widely followed asset
allocation expert. He argued that wealth managers have "overgrazed"
in wide asset allocation. Here is how he stated things
recently:
Bernstein:
Yes. So, that's the first aspect of it, the return aspect, the
overgrazing. The first person to the party gets filet mignon, the
last person to the party gets a hamburger or worse. And
unfortunately everybody is trying to be little David Swensen
right now, and not everybody can be David Swensen.
But there is second aspect of it, as well, which is the
correlation aspect. The first people to the party, the first
people to invest in a new asset class or the first people to
invest in a recently disgraced asset class that's had a
catastrophe--it doesn't have to be a new asset class, it can be
an old one that's gotten hammered--the first people tend to be
very disciplined. They tend to have very strong hands. They will
hold on during the market decline. But when everybody and their
dog owns the asset class, when the average exposure to
alternatives, for example, in an university endowment is well
over 50%, a lot those people are going to be weak hands. They're
going to be people who will sell at the first sign of trouble.
And when that happens, the correlation goes way up, and the
classic example of that recently, of course, was commodities
funds. The correlation now with commodities funds with the stock
market since the crisis is in the range of 0.7 or 0.8; it used to
be much lower. And that appears to be a permanent condition, that
appears to be a permanent shift.
At our firm, it appears that overgrazing has occurred in every
asset class which has received massive inflows motivated by
economic and stock market fear in the US or by the erroneous belief
in China's uninterrupted growth. Take a look at what are the most
popular writers of weekly and monthly macroeconomic and US stock
market timing advice, and you see a list of extremely bright
pessimists. These pessimists are contributing to the "overgrazing"
of popular asset classes and have scared most of the animals away
from taking risk in the one asset class which offers under-grazed
territory. Using commodities as a favorite of the pessimists, here
is what Bernstein said in an answer to one of Christine's
questions:
Bernstein:
Well, that's an interesting issue. Commodities were first noticed
as a diversifying asset class back in the early '90s when the
data first became available from the Goldman Sachs Index. And the
problem was that before 1990, you couldn't really get exposure to
them and unless you are the very biggest of players like David
Swensen. What you have to do is literally jump into the pits and
deal with these futures; you couldn't actually buy a fund, or a
simple vehicle that did it. You had to find at best a manager
that could do it for you. And those were very thin on the ground.
You didn't (
KNOW
) who they are, and very few people knew about this asset
class.
The more people who found out about it, the more the alpha got
overgrazed. And with commodities there is a very easy way of
measuring how overcrowded it is, which is what's something called
the roll return which is the difference between the futures index
and the spot index. And that became negative sometime around 10
or 11 or 12 years ago, and it has been persistently negative ever
since as the PIMCOs and the Oppenheimers and the Goldman Sachs
and the Yales of the world have all piled into it.
Therefore, in our opinion, commodities as an asset class (along
with blackjack, sports betting, the craps table, etc.) are a
severely negative sum game.
Which asset class is under-grazed because of a severe reluctance
on the part of wealth advisors and their clients? Lipper has
reported that large-cap US stock mutual funds have suffered 41
consecutive months of liquidation, despite clobbering the returns
of most of the other asset classes. Wealth advisors have been
convinced by the brilliant pessimists to keep very low commitments
to US stocks. The NACUBO study shows that dollar-weighted US equity
holdings among endowments and foundations dropped from 36.7% of
overall portfolios in 2002 to 15% by the end of 2010. They are
likely lower now, if Lipper's information and anecdotal evidence is
valid.
Why do we believe you should be optimistic about US large cap
equities at the present time? 1) Valuations are below historical
averages, especially compared to interest rates and inflation. 2)
Dismal economic prognostications are everywhere and any surprise to
the positive is not discounted. 3) The US has 85 million
echo-boomers averaging around 28 years of age. Aging will drive
them to marry, have kids and buy houses and houses have never been
this affordable in my lifetime. 4) China's economy is slowing even
before they admit that unpaid loans from 2008-2011 could cripple
their financial system. We believe commodities have entered a 5-7
year bear market and that the stimulating affects of lower oil and
other commodity prices will be huge. 5) The dearth of optimists
makes the risk-reward relationship incredibly positive and
under-grazed.
As portfolio managers of a US large cap stock portfolio, this
means we must be incredibly careful with the energy, basic
materials and heavy industrial sectors of the S&P 500 index.
They have suckled on China's uninterrupted growth and the commodity
boom. Second, we believe we are receiving bargains among what we
call "staple" consumer discretionary companies with addicted
customer bases. Third, we like the money which we think we can make
from dealing with baby boomers living long lives with chronic
illnesses treatable with pharmaceutical products. Lastly, we like
the US financial institutions which will benefit from any positive
surprises about our economic future.
In summary, while everyone is looking to reduce risk and is
accepting little or no return in the process, we argue that seeking
out well-chosen risk in the under-grazed US large-cap stock market
is the thing to do. After all, isn't that what introductory
economics classes have taught us?
Disclaimer: The information contained in this missive
represents SCM's opinions, and should not be construed as
personalized or individualized investment advice. Past
performance is no guarantee of future results. It should not be
assumed that investing in any securities mentioned above will
or will not be profitable. A list of all recommendations made
by Smead Capital Management within the past twelve month period
is available upon request.
Disclosure:
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.
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