The Puget Sound Group Quarterly Newsletter June 2014 It isn t what you earn it is what you keep that matters in investing. While systematically underwriting too little risk may mean that you do not earn all that you might, underwriting too much towards the end of a business cycle can be disastrous. With this in mind, it becomes obvious that timing an investment strategy may be the most important single decision an investor needs to get right i. Tad Rivelle, TCW, Understanding the Boom and the Bust I find the above quote quite interesting considering the following context: Financial academics have told us for at least the last decade that market timing is historically responsible for only a small part of returns, and it is time in the markets and asset allocation that matter ii. Much has been written on the subject and one only needs to look at a chart between 2007 and 2014 to recognize that while markets ebb and flow, despite the greatest financial calamity since the great depression, the S&P has gained back not only what it lost but significantly more. S&P 500 Aug 2007 Apr 2014
However, what if you had invested money in October 2007 in an exchange traded fund representing the S&P 500, like the State Street SPY? You would have watched your $100 turn into $48 by April of 2009. The fund would go on to climb from 74 to 191, some 159% higher but your original $100 would still only be worth $76, not including dividends. In other words, despite one of the strongest market recoveries of our time, had you purchased stocks at the wrong time you would still not have your money back. Despite what some of the experts may say, I believe market timing can have a large impact on the longterm success of an investing strategy. Therefore investors should have both the information and the tools to make timely and educated investments. This leads us to the logical question: Where does that leave us today? After a stellar 2013, many analysts including Morgan Stanley s Chief Investment Officer, Mike Wilson, believe markets are poised for high single digit returns iii. In a nutshell, they say the US economy is growing albeit slowly and Europe is recovering. My job as the Senior Portfolio Manager is to weigh the data and construct the portfolios accordingly. I ve laid out the following charts to provide a backdrop of some of the good, the not-so-good, and the bad data. The Good U.S. Corporate profits as a percentage of GDP continue to grow, and at the same time, total leverage defined as the ratio of debt to total equity remains at historical lows iv. Translated, US companies are more profitable than ever before and are using less leverage to be so.
The amount of debt payment as a percentage of disposable income remains at historical lows, while household net worth has reached an all-time high v. In other words, consumers burdened by less debt payments are not only feeling richer but actually are. We used a similar chart last quarter as part of our long-term thesis for rational optimism for the US. The story has not changed The US continues to produce more natural gas at lower prices, and import less foreign sources of liquid fuels as we utilize our own production instead vi. I feel that not only does this mean more US jobs, but also a significant portion of long-term price inflation can be explained through energy imports, so more domestic production could portend to more stable inflation expectations.
In general economic terms, Gross Domestic Product consists of three broad inputs: Consumption (consumers) + Investment (business) + and Government. Though the Investment portion of the equation has recovered since 2009, businesses still have not reached the historical average, which could imply further upside vii. The Not-So-Good As the equity markets have continued to move higher, stocks are no longer cheap. As a matter of fact, they are considerably more expensive than the 10-year average and only slightly below the 15-year average, which included the rational exuberance of the late 90 s viii. After a 30+ year period of declining interest rates ix, investors are now left searching for yield. Fixed income investors want higher rates because that usually means higher income, but higher rates also leads to price erosion on existing bond holdings and growth in the economy can potentially stall.
While Real GDP growth has certainly recovered from the market lows of 2008/09, real GDP growth year over year still has not reached its 50-year average x. The Bad I believe current and long-term debt in the US continues to be a problem. The 2014 Federal Budget shows the US Government borrowing $514B (15%), or approximately $43B per month to keep the economy going. Likewise, accumulated deficit projections show Federal Net Debt continuing to grow to 79.4% of GDP from approximately 35% in 2007 xi.
Civilian Unemployment reached a high of 10% in 2009 and by February 2014 dropped to 6.7% xii. On the surface these numbers would suggest unemployment, defined as working age people actively seeking employment, are improving and therefore this is all good news. However, as the definition suggests one must be actively seeking employment to be considered unemployed. What s another way to lower the unemployment number? Simply stop looking for a job. Labor Participation has never been this low before xiii. Where does this leave us today? Clearly, since the great recession both businesses and consumers have made progress in repairing their balance sheets. They ve been assisted by an accommodative Federal Reserve policy that pushed shortterm interest rates low in an effort to create a more conducive environment for borrowing and lending, thereby increasing demand for other assets such as stocks and real estate. Last year the Federal Reserve began to pull back on the accommodative stance through a systematic slow down on bond purchasing, known as the taper, which longer term will normalize interest rates but has the potential to hinder the ability for both businesses and consumers to borrow and/or consume. Only time will tell. That being said, the extent to which how much rates will normalize (e.g. move higher) is much debated. If 2014 is any indicator (the 10-year treasury yield has fallen; beginning the year at 3.04% and dipping as low as 2.42%), very few analysts have any idea where rates will be a year from now. After all, how many predicted Japan would have nominal 10-year treasury yields of around 1% for 15 years xiv? As it relates to our portfolios, we maintain constructive on equities albeit with a watchful eye, and are careful to the manner in which we invest in bonds. We will maintain our stance provided growth in and outside of the US continues at moderate pace. We continue to be overweight in energy, which has performed well this year, due to our long-term thesis of US energy independence and the positive impact it could have on the US economy. We feel the summer is generally a period where market movement can be sporadic, as traders and portfolio managers take summer vacation so we are prepared for bit more volatility. In summary, long-term investors would be advised to stick to their investment plan provided it matches with their financial needs and goals. If you feel that your investment plan may not match your long-term wealth strategy, our team has two Certified Financial Planners and a Financial Planning Specialist who can help create a plan that is built around your specific needs. For investors looking to allocate new money, provided you have a financial plan and an investment strategy (such as ours) that can shift to a more defensive stance if need be, now is always a good time to invest somewhere. Nicholas Paget, Wealth Advisor, First Vice President, Senior Portfolio Manager
S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market. An investment cannot be made directly in a market index. Information contained herein has been obtained from sources considered to be reliable, but we do not guarantee their accuracy or completeness. The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Wealth Management or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results. i https://www.tcw.com/insights/market_commentary/insights/04-17-14_trading_secrets.aspx ii Funds, Pioneer. "Pioneer Ibbotson Asset Allocation Series." Pioneer Ibbotson Asset Allocation Series (n.d.): n. pag. Www.pioneerinvestments.com. Web. 21 May 2014. iii Wilson, Mike. "On the Markets: Starting the New Year on a High Note." Morgan Stanley Global Investment Commentary (2014): n. pag. Web. 23 May 2014. iv Standard & Poors, Compustat. JP Morgan Asset Management, Guide to the Markets: page 8. EPS Levels are based on operating earnings per share. v BEA, FRB, J.P. Morgan Asset Management, Guide to the Markets. Pg. 19. *1Q14 household debt service ratio and household income net worth are JP Morgan estimates. vi EIA, J.P. Morgan Asset Management, Guide to the Markets Pg. 28. Forecasts are from EIA Annual Energy Outlook and start in 2013. vii BEA, Federal Reserve, Fact Set, JP Morgan Asset Management, Guide to Markets. Pg. 22. 31, March 2014. viii Standard & Poors, FactSet, Robert Schiller Data, JP Morgan Asset Management, Guide to the Markets. Pg. 7. 31, March 2014. ix Federal Reservce, BLS, JP Morgan Asset Management, Guide to the Markets. Pg 31. 31, March 2014. x BEA, FactSet, JP Morgan Asset Management, Guide to the Markets. Pg. 18. 31, March 2014. xi US Treasury, BEA, CBO, JP Morgan Asset Management, Guide to the Markets. Pg. 23. 31, March 2014. xii BLS, FactSet, JP Morgan Asset Management, Guide to the Markets. Pg. 24. 31, March 2014. xiii BLS, FactSet, JP Morgan Asset Management, Guide to the Markets. Pg. 25. 31, March 2014. xiv Bank of Japan, OECD, IMF, FactSet, JP Morgan Asset Management, Guide to the Markets. Pg. 51. 31, March 2014.