Plethora of Possibilites – July 2012

July 24th 2012

Dow Jones Average: 12,617
S & P 500 Index: 1,338

Plethora of Possibilites 

We have not witnessed a time in the past thirty years when investors had less conviction in their investment choices than they seem to have now. Successful investing comes from the early identification of a macro-economic trend or an important development at an individual company. From such analysis an investor builds conviction in a particular scenario or outcome. In the absence of clear analysis and conviction, the markets can take on a casino atmosphere where people place ill-considered bets.

One of the largest and most respected mutual fund firms, PIMCO, has explained the current investment environment as a flattening of the bell curve of possibilities. Typically the most extreme outcomes at either end of the bell curve have a low chance of occurring, while the middle or normalized economic outcomes make up the consensus forecast. At the present time, according to PIMCO, anything seems possible, the extreme outcomes just as likely as the more typical economic patterns. This assessment, which is shared by many investors, explains the very flat performance of the major market indices over the past eighteen months. Too many conflicting, plausible scenarios have stymied the markets, leaving many stocks locked in narrow price ranges.

It is not surprising that investors and the public at large are concerned and uncertain about the economic future. While the debt crisis and recession gripping Europe is old news, it is still impacting business conditions around the world. For the first time since 2008 the Chinese economy is slowing noticeably, partly due to a fall off in European sales. China has other problems as well; including overbuilt housing and industrial sectors. Slower growth in China means less business for commodity suppliers in countries such as Brazil and Russia. While the upside of a tightly connected global economy is larger markets for products and services, the downside can be ripple effects that spread problems from one region to another.

The confusion and frustration investors feel about the macro-economic environment impacts their behavior toward individual stocks. Any company that appears to be doing well, in a world where so much is going wrong, is treated as a lifeboat. Investors pile into the shares of such companies, pushing the stock price to lofty levels. But if anything goes awry, if the boat starts to leak at all, panic ensues. This happened recently with Green Mountain Coffee, Netflix, and Tempur Pedic, among others too numerous to name. After soaring by several hundred percent the three companies mentioned capsized, losing about eighty percent of their value very quickly.

By keeping interest rates at historically low levels for years on-end, governments around the world have forced investors into placing bets on stocks and bonds, without much conviction behind those decisions. Many investors are reacting to the low return environment by overpaying for companies that seem certain, and by buying government paper at lower and lower yields. Neither of these strategies has much chance of success over a longer time frame in our opinion.

Current Strategy

Stock prices in the U.S. are generally in the middle of the long-term historical valuation range for equities. Prices could just as easily move higher or lower from here. In Europe and Japan valuation levels are more depressed as the economic backdrop in those areas is weaker than in North America. Price appreciation in stocks often springs from periods of angst and uncertainty. As the dark clouds clear, investor confidence builds and prices advance. That pattern could repeat if policymakers successfully address the debt crisis in Europe, the slowdown in China, and the fiscal cliff (expiration of tax cuts and automatic budget reduction) at year end in the U.S. It is a lot of ifs that need to be resolved soon. We often have a strong sense of election and other policy related outcomes. That is not the case at this time. Our crystal ball is unusually cloudy.

Devising a strategy when our conviction level is low is challenging, but not impossible. There are three possible paths that make sense depending upon the risk profile of an investor. If capital preservation is of the utmost importance, it is probably better to err on the side of limited action, waiting for a break in the political stalemate or a break down in stock prices. That could be a long wait, and is not suitable for all clients. For clients willing to take more risk or those who mandate more equity exposure, the best strategy, in our opinion, is one that covers a number of different economic and market scenarios. This means more market exposure, and will not protect against the worst outcome, i.e., a general asset meltdown as occurred in 2008. The third option is a blend of the first two strategies, committing a meaningful portion of the portfolio to the multi-scenario approach, while keeping a sizable portion of the account in stable assets such as t-bills or money market funds.

The fixed income markets continue to set new lows in terms of yield. In six countries, mostly in Northern Europe, investors are experiencing negative yields, actually paying a charge to have their cash invested in zero percent, government paper. Things are not much better in Germany, Japan, the U.S., Canada, Switzerland, etc., where returns on ten-year government bonds range from .5 percent to 1.4 percent. The Treasury Inflation Protected Securities that we have used extensively over the past ten years have negative yields before the inflation adjustment is calculated. In this barren yield environment we are looking to stock dividends for income and are considering bond funds for the first time. The two funds we are evaluating specialize in U.S. mortgage paper (an improving area in our opinion), and emerging market debt. The funds offer a measure of diversity and liquidity that cannot be attained through buying individual mortgage or emerging market securities.

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