Market Commentary

From Your Risk Manager, Redux

April 2011

"The essence of investment management is the management of risk, not the management of returns." – Benjamin Graham

Risk is the permanent loss of capital, never a number." – James Montier

The risk trade is on. We think that investors are in a circumstance where taking risk is extremely appealing. What is encouraging risk-taking?

In the stock market, nothing succeeds like success. One of our most human traits is to take our current state of affairs and extrapolate them forward. This particular proclivity is due to the way our brains are wired. This is as fraught with problems in our emotional and social lives as it is for any expectations about the markets. After a huge rally in the market during the past two years, we observe that many investors have reached, again, a fair degree of complacency about how risky the stock market is. We read about the 'macro trade' of large investors buying large buckets of stock market ETFs in order to participate in the broad market, regardless, it seems, of considerations like company, financial stability, or price.

We don't think that stocks generally are terribly expensive, however we don't think they are terribly cheap, either. Small company stocks are quite extended, as are some emerging markets. We continue to think it makes sense to participate in the stock market, as it is a very good vehicle for the type of long-term returns that get you past inflation and taxes. To do so we are not interested in the generic equity market exposure of the 'macro trade,' however, but in well-capitalized, well-run companies that are cheaper than average - essentially 'on sale.' At present, a well-run group of blue-chip U.S. companies, which sell a predominance of their product and service overseas, fit this description. The core managers with whom your portfolio is currently invested have significant holdings of such companies.

In the bond market, we think risks are newly emergent at the longer term end of the investment spectrum there. We worry that the bond market will decide over the course of a short period of time sometime soon that inflation is coming. As investors anticipate interest rates rising and then experience inflation, the price and then the purchasing power embedded in existing bonds never recovers. That is permanent capital impairment manifest in the bond market.

For the purpose of avoiding this, we do not have you invested in overly long positions in the bond market. Your portfolios tend to have a weighted average duration under two years, where we expect adequate price stability. Even overseas, where there are nations that currently have less interest rate risk than the U.S., there are enough potential dislocations that your international bonds are also of reasonably low duration - around two and a half years at last measure. We are glad we sold many longer-term municipal bond positions ahead of all the drastic headlines about the municipal bond market that developed this winter. True to our discipline of wanting to buy good investments cheaply, we are anticipating at some point there being an opportunity in these bonds, but it may be some time in coming.

What of the risks of inflation? For two years after the crash, we thought that it was really an impossible call to know what - deflation or inflation - was coming. We think it is still a tough call, but we think the environment now favors an inflationary scenario in the U.S. There literally are too many dollars sloshing around. In places where supply is under stress, such as with gasoline, cotton, and coffee, we are seeing prices rise dramatically. Previously, during the credit crisis and when the economy was dramatically slowing, these same prices might not have risen.

Now does this mean that inflation is guaranteed? Absolutely not. We are watching the budget debates shape up in Washington D.C. with great interest. Large federal spending and investment and generous interest rate policy has largely offset the weak private economy during the past several years. We think that big federal spending cuts, should they come in the next few years, could impact the fragile economic stability we now have. We consider the middle of the Great Depression in the U.S., when amidst a fragile economic recovery in part supported by federal government spending, we cut government spending dramatically and created a whole second phase to the Great Depression. While history never exactly repeats itself, it sometimes rhymes, so we continue to position your portfolios for both significant outcomes - inflation and deflation. We think that when inflation comes, as it eventually will, the bond and stock markets will react quite negatively - a key reason while we continue to have you somewhat less fully invested than usual.

We can't eliminate risk, but we can manage it by staying away from faddish trades, keeping with our and your managers' discipline of buying quality companies on sale, and watching out for situations that could permanently impair your capital.

This is a general assessment of client portfolios and does not reflect the specific circumstance of every client.

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