Market Commentary

Thinking and Choosing

October 2014

"The contrary investor is every human when he resigns momentarily from the herd and thinks for himself" – Archibald MacLeish

"This is not about market timing. It is about carefully choosing your starting point.'" – Dave Rosenberg

We've been busier than usual in your portfolios this year. We've introduced a few new managers, and cautiously moved into a few new areas in your portfolios. While we remain convinced that the US market is overextended and expensive, we also see in hindsight that our cautious positioning over the last several years has led to missing much of the outsized gains in US stock prices.

Our philosophy remains intact, though, and while we expect to continue to selectively increase equity allocations in areas where we see opportunity, a larger shift to a heavy equity emphasis remains in future. We want to protect your capital as well as position it for steady and long-term growth; and we work hard to find the right balance between the two, and to be ready to make forays into risk assets once they are priced appropriately.

What about the current environment? We're six years into a market expansion in the US that has been fueled more than anything on wave after wave of liquidity provided by regulators who have pulled out all the stops to create a semblance of economic normality coming out of the financial crisis of 2008-2009. In fact, it's been coherently argued that we haven't seen such expansionism in a nation's supply of liquidity since Napoleon's immediate predecessors expanded France's balance sheet in the late 18th century.[i] Non-US stock markets have not performed as strongly this year, both due to economic limitations and more recently an appreciating dollar. As of the end of the third quarter the S&P was up 8.3%; the MSCI EAFE index of developed markets was down -1.4%.

We do have economic growth in the US, but given the stimulus provided, even that has been tepid and bumpy. Growth has inordinately benefited the top income tiers, and 2/3 of the new jobs counted in now-rosier employment numbers are part-time jobs, so some of the statistics are hollow. On the earnings side, cheap money has encouraged large companies not necessarily to reinvest capital from record profits into product and service development, but instead more companies recently are taking on debt with which to raise cash to buy back their own shares – and historically companies tend to do this at market tops.

So, we are afloat on a sea of cheap money, and have had a hollow kind of economic growth. The cost of money and the growth of the economy are two of the three major drivers of future stock returns. Which brings us to valuation. Valuation is the third leg of the stool of these major drivers of future stock returns. Stocks are currently priced as if high levels of future growth are certain and low interest rates (i.e. cheap capital) will remain in place indefinitely. Bonds are also somewhere near a long-term high in terms of what we can expect given current yields both in U.S. and foreign government debt, and in the corporate credit markets. So, while we've added a few new managers to your portfolios this year, the additions have been incremental. On the bond side, we've moved risk away from general interest rate risk and towards well-researched credit and currency risk.

In fact, because some of your stock managers have themselves sold more than they have bought in this environment, you haven't become more fully allocated to stocks even as we have added stock opportunity, selectively, in your portfolios. We are monitoring this effect carefully, and you are likely to see portfolio trades this fall that are oriented to keeping your stock exposure stable in this environment where some stock managers are holding record amounts of cash awaiting opportunities.

We've continued to hold some gold and gold-related investments for you. While the rally in these holdings earlier this year has recently reversed itself, we haven't traded out of these investments. We've not seen a change in this hollow market that warrants less of a hedge in this regard, and are more likely to increase stock manager allocation to take advantage of drops in valuation. We are monitoring this closely as well, particularly in concert with high cash levels in value-oriented stock managers' portfolios, as we don't want you to become overly hedged.

One advantage of adding allocation to cautious stock managers in your portfolios is that there will be timely additions to the stock side of your portfolios at lower price levels, when they do come. After three years without a significant correction, we think investors, grown somewhat complacent by steady strong returns, will possibly overreact to the downside and provide opportunity for entry at lower price levels. We are ready to go when this time comes, as we look for the right starting point to have more heavily invested stock portfolios.

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

[i] 'Welcome to the Revolution,' Grant's Interest Rate Observer, May 31, 2013

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