The U.S. government is open for business once again after giving employees a two-week paid vacation and the debt ceiling has been temporarily raised. Both of these will come up for further review at the beginning of next year because, in its typical fashion, Congress could not reach agreement on a more permanent solution, but at least we’ll get through Christmas with a minimum of Washington anguish. What is more troubling is the third-quarter earnings season results so far. With half of the Standard & Poor’s 500 companies having reported, almost 70% are “beating” their earnings forecasts; however, the estimates had been revised downward continuously as we moved closer to the reporting date. There have also been some notable disappointments like IBM, McDonald’s and Caterpillar. What’s more, companies that do provide guidance to analysts are encouraging them to lower their estimates. Revenues have consistently risen much more slowly than earnings, which could be a profit warning for 2014. That’s disappointing in an economy where the Federal Reserve is providing a trillion dollars of monetary stimulus this year.
In 2008 the total balance sheet of the Fed was $1 trillion and Treasurys represented less than 10% of it. Today the Fed balance sheet is about $3.5 trillion and Treasurys account for about 25%. Fed Chairman Bernanke was beginning to feel a little uneasy about the amount of U.S. government securities on his balance sheet in May and that’s why he hinted at tapering. In June he must have had a premonition about the looming budget and debt ceiling problems and pulled away from tapering talk. Those concerns also may have been one reason why he decided not to taper in September. Another was the turbulence in the bond and mortgage market caused by the suggestion of tapering itself. Now any reduction in the monetary stimulus program has been deferred to 2014 when a new Fed chairman, Janet Yellen, will be in charge. She is likely to be as accommodative as Bernanke or more so.
In addition to a prolonged period of monetary easing, other favorable market-influencing factors are in place. Europe will probably show modest growth next year and China’s Gross Domestic Product (GDP) should expand at more than 7%. I still would like to see more structural change in Europe, including movement toward a banking union and more fiscal discipline. I would also be encouraged if China could rebalance its economy with more consumer spending and fewer investment and infrastructure projects using borrowed money. Positive news from these important contributors to world growth is good for developed country equity markets. Japan is in a consolidation mode now but growth in 2014 should be 1%–2%, with some inflation and higher Japanese government bond yields. Shinzo Abe’s expansive fiscal and monetary policy strategy is risky, but it seems to be working so far. In the meantime inflation almost everywhere remains modest, oil prices are stable or declining and household net worth is increasing as a result of higher equity prices and improved property values. This has resulted in generally favorable consumer sentiment readings, although these have not yet improved to 2007 levels. Consumer sentiment declined during the budget and debt ceiling harangue, yet it is likely to recover over the next few months.
There are also the lingering questions of whether Syria will really surrender all of its chemical weapons and whether Iran will negotiate a modification of its nuclear program. Perhaps the most powerful force driving stock prices higher around the world on an almost daily basis is the fact that valuations are not excessive. On an earnings estimate for 2014 of $115, the Standard & Poor’s 500 is only selling at a little over 15 times earnings, which would be considered fair value on an historical basis. This valuation is a long way from the overvalued levels of 1999 and even 2007. An analysis by International Strategy & Investment (ISI) shows that if profit margins hold at present levels, revenue growth will have to be 5% for the S&P 500 earnings to reach $115. This assumes a 1.5% share buyback program for companies in the index.
I think margins may be peaking. But even if they are not, a 5% increase in revenues may be hard to achieve. I also think share buybacks will be critical in 2014, as they have been this year. There are, however, some disturbing signs of speculation. Margin debt is at an all-time high. I realize some of that is because of hedge funds neutralizing the risk in their portfolios and not all of it is caused by retail investors taking on more stock than they can afford, but an all-time high in margin debt is indicative of “animal spirits.” I also think a low level of volatility shows that most investors are complacent. The major problems facing the market this summer have diminished and fears they had have subsided.
In this environment, what asset allocation makes sense for institutional investors? While the total return for the S&P 500 was more than 16% in 2012 and has been 23% so far in 2013, I still believe there is further upside ahead, but a temporary correction from an overbought condition could occur at any time. Two years ago I suggested a “radical” asset allocation for institutional investors to take advantage of the opportunities I saw ahead. The portfolio was designed to produce a high-single-digit return over a full market cycle. I have made some changes over the past 24 months and am making further adjustments now. I explained that this portfolio would be more volatile and less liquid than the asset allocation structure most institutions were used to, but I thought the long-term returns would justify these differences.
This revised portfolio was created recognizing that world growth may be below expectations in contrast to the widespread forecasts of a significant pick-up in economic activity, particularly in the United States. I expect modest earnings increases and some multiple expansion from present levels, but I doubt that we will have another year of double-digit increases in the market indexes. My view is that the industrialized nations are suffering from a lack of demand sufficient to absorb the abundant supply of quality goods produced by many countries across the world. As a result unemployment is likely to remain high and capital spending, ordinarily contributing importantly to growth at this stage in the cycle, will remain low. Operating rates in the U.S. are below 79%; capital spending picks up when they are in the mid-80%–90% range. Consumer sentiment is likely to remain unenthusiastic in this environment, preventing retail sales from reaching a robust level. A recent article in Barron’s quoting several academic studies pointed out that demographic factors (aging populations) and only slight increases in productivity will hold U.S. growth well below the 3½% of the post–World War II period, perhaps as low as 2%. This will have both social and political implications, particularly with potentially growing entitlement expenditures putting pressure on the budget deficit.
I continue to have a 10% position in high-quality global multinationals. These stocks have generally done well in this bull market, but they are not overvalued and continue to provide a reasonable yield with moderate earnings growth. Many of these companies are based in the United States. I also have a 10% position in small and medium capitalization American companies.
I have a 10% position in European stocks. Europe pulled out of its recession in 2009, but slipped back into one over the last two years. I believe investors will see modest growth in the region in 2014 and valuations are reasonable. I also have a 5% position in Japan. I expect further appreciation in the Nikkei 225 from present levels based on improving fundamentals. Finally I have a 10% position in emerging markets. This has been a disappointing category over the past two years as these economies have slowed. Growth is still greater than in the developed world, but the equity markets for most emerging countries have been poor. Valuations are very reasonable, profits are growing and I think we will see better performance in 2014. The five positions outlined so far represent 45% of the total and are the long-only base of the portfolio.
I continue to think that institutional portfolios will benefit from a commitment to alternative investments. I have a 10% position in hedge funds because I have seen them provide strong risk-adjusted returns over a full market cycle. I have a 10% position in private equity because there will be a number of high-return opportunities in the years ahead as companies sell off divisions to rationalize their strategic operating structure. I believe leveraged buyouts will play a smaller role than they have in the past years. A private equity firm can be patient in waiting for opportunities which will benefit from improved management and adequate financing. Superior returns will compensate investors for the lack of liquidity.
I have a 10% position in real estate. This has been a source of high returns for the portfolio. In contrast to past cycles when ambitious developers overbuilt when the economy was doing well only to run into trouble during the recession, there was much less speculative construction in the last cycle. As a result real estate reached a bottom about the same time the economy troughed rather than lagging through the initial phase of the recovery. When the recession ended, occupancy began to improve almost immediately. Fewer vacant buildings desperately sought tenants; rents improved later. Returns in this sector exceeded most of the other categories in the portfolio.
I have two commodity-based positions in the portfolio. The first is a 5% position in gold, which has hurt the performance of the portfolio this year. I believe gold reached a speculative peak in the spring with many individual investors buying gold Exchange Traded Funds. When the price began to decline, they sold furiously, resulting in a precipitous drop in the price. Much of that gold was bought by Indian and Chinese investors who are likely to hold it long term. If there is renewed interest in the metal for any reason, the price is likely to rise sharply. It does seem, however, that gold does not act as a store of value in the face of monetary expansion and declining currencies. It also may not be the insurance policy against a calamity in financial assets that I and others have thought. A study by analysts at Zweig-DiMenna disproved that theory. I believe gold will recover next year because of a renewed interest in real assets as the equity market returns become more modest. I have a 5% position in natural resources and agricultural commodities. This sector has been disappointing, as well, but in the longer term I believe the rising standard of living and better diets in the developing world coupled with uneven weather conditions causing crop failures will result in rising prices for commodities.
Finally I have a 15% position in high yield securities. These are not conventional high yield bonds where yields have dropped sharply over the past two years, but mortgages, leveraged loans and mezzanine financing where attractive yields are available with a minimum of risk. I have no position in U.S. Treasurys because I expect yields to rise on these notes and bonds over the next year. The ten-year U.S. Treasury has typically had a yield roughly congruent with the nominal growth rate of the United States. That would be 2% real growth and 1½% inflation, or 3½%. The current yield is 2½% so a capital loss near-term on these instruments is likely, in my opinion, but Treasury yields have remained low for a lot longer than I thought they would.
Overall I have made 25 percentage points of changes in the portfolio. I established three new categories, long-only United States and long-only Europe at 10% each and long Japan at 5%. To provide funds for these new positions I trimmed 5% from emerging markets, 5% from hedge funds, 5% from real estate and 5% from non-conventional high yield, and I eliminated the 5% cash position. I know it is customary to maintain at least a small cash position in institutional portfolios, but a 5% position will not provide much protection in a market downturn and the yield on cash today is negligible. The increase in the liquid long-only portion of the portfolio should provide whatever funds are needed for distributions or for investing in any exceptional opportunities that may develop. The alternative investments were reduced by 10% and the long-only investments were increased by 25%. Now let’s see if the portfolio is properly structured for a more difficult 2014.
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