2008 will most likely be remembered with the same sense of dread as any year since the Great Depression. By whatever measure (performance of the S&P 500, increases in unemployment, etc), 2008 was one of the most challenging for the economy, and for the capital markets, in the last 50 years. While there are many specific reasons for why - primarily related to declines in the housing market, underwriting standards and the excessive use of statistical methods in portfolio management - the primary reason why we saw such broad based declines in virtually every asset relates to a general collapse in trust.
By and large, trust appears to be returning and the capital markets repairing themselves. Most of the risky asset classes have appreciated significantly from lows established in November, with the notable exception of commodities. Most strikingly, corporate bonds by the higher rated issues appear to have fully recovered to pre-Lehman levels. High Yield ("Junk") bonds and preferred stocks have also staged impressive gains and, arguably, the credit crisis has ended. Equity markets remain mired at dismal (although higher) levels and are effectively as cheap as they have been since the 1970s- particularly in comparison to government bond yields. There remains strong expectation that corporate profits have declined and there is a lack of confidence in the accounting and financial projections of public firms, despite the intense regulation that has been imposed post Enron in the form of Sarbanes Oxley.
Stocks have always taken longer to recover from panics than other investments. This is because trust and confidence are much more easily destroyed than they are built. While the causes of the recent collapse in equity values were the product of an overreaction to what was happening in the real estate and banking sectors, what a rapidly reveals are the misrepresentations and outright fraud inherit in capitalism and an eternal component of Wall Street. Where confidence can be restored in the mortgage and bond markets relatively quickly - once investors keep getting their interest and principal payments they soon return to buying (particularly if the rate on cash is effectively negative), stocks require trust, confidence and faith in the future.
Recent events in the political space (Blagojevich) and financial (the recent revelations of corrupt practives at the rating agencies and Bernard Madoff) are part of why stocks will take a while to recover and while the riskiest stocks will probably be last to see significant capital appreciation. The quickest and most stark punishment of evil will have the best effect of repairing investor psyches in the short term, and thus the markets, but it is reasonable to expect that more ugliness and shame will appear in the headlines in the coming months, leading to volatile equity markets. And, rarely is the best solution for the short term, the best choice for the long term. Repairing the system that allowed for these abuses of trust to exist will require deliberation, debate and trial and error. There has been far too much seeking of a quick fix for our short term problems (like stimulus packages or the demand for a relaxing of accounting standards) at the cost of the long term stability (balancing federal and municipal budgets or encouraging Americans to return to long term savings strategies). Equities are a long term investment, and their performance is affected by long term trends.
This is not to say that current forces are not highly supportive of a near term equity rally. The ever expanding stimulus package proposed by the President and congressional leaders will likely stimulate great short term economic growth. Infrastructure investment, when properly spent, can have tremendous long term benefits to the aggregate economy. The national highway system, mass transit, the Internet and space exploration have all been government inspired infrustructure investments produced benefits far exceeding their cost. But the concern that I have is that in this environment of universal agreement that piling on more debts is the answer, cronyism and waste will likely result. The dominance of one political party (and yes, particularly the Democrats) doesn't help discourage me from this concern. I fear that massive "investments" will do little more than create long term problems of inflation and benefit obligations for newly created unionized laborers with little long term returns. There were several efforts to use the broadsword of government power to bring the economy out of recession in the early 1970s which probably made problems worse.
So, against this backdrop of uncertainty - what is one to do?
The answer is, I believe, very different depending upon a wide variety of circumstances (as it always is) and in each client's case, I am approaching the question of asset allocation and investment selection differently. While there are certain consistently logical approaches, such as maintaining exposure to blue chip, solid brand stocks (as represented by my Fortune Most Admired Companies strategy). However, I will discuss broadly my approch depending upon risk tolerance (remembering that each client is different):
For Aggressive investors, probably the most attractive equity investments remain US Large Growth companies, Emerging Markets and High Yield Bonds. I have generally been reluctant to enter back into emerging markets in a major way, but over the course of the next few months, I am increasingly interested in investing in this space. Emerging markets are currently very beaten up and the valuations look attractive, but this may be a several year story to work out. This is particularly true if oil remains at these depressed levels. Most emerging economies are heavily dependent upon resource intensive industries and this will likely have complicated and frequently conflicting economic and political impact. Broad diversification makes the most sense as a risk management strategy. But, for investors with patience and a long time horizon (20+ years), this seems like an obvious play given the eviceration of most emerging countries' equity markets over the last few months.
For Moderate investors, I am, and have been, adding Preferred Stocks, High Yield Bonds and Blue Chip stocks. High dividend yields are encouraging as has been strong support for the banks who are the primary issuers of preferreds. Given the unlikely event of significant calls of preferred or bond issues, this is particularly so. However, volatility is to be expected in the coming months, as more of the problems I alluded to emerge. I have also generally moved cash to bonds in these accounts, as I have been enticed by higher rates of interest than earlier last year and the capital gains that the recovery of bond and stock markets have delivered. I remain very concered about the potential problems that are likely to emerge within municipalities over the next few years, but I think that selective purchases in this space (coupled with a tolerance for volatility) may make sense - particularly in light of the effective total recovery of the corporate bond markets and what are now less attractive rates of interest. Inflation indexed bonds also make sense, as the likelihood of high inflation is considerably greater with all of this government debt issuance and the fact that investment markets seem to have completely ignored this possibility, pricing expected inflation at about 1% over the next few years.
For Conservative investors, well, this is a tough one. 2008 was a year of extreme volatility for "conservative investments" (bonds issued by banks, mortgage backed securities, inflation indexed bonds, etc.) Given the inherit reluctance of a conservative investors to take on risk, but balanced against the extreme attractiveness of risky assets, I am inclined to allocate equity money towards US Large Cap stocks (in particular the Fortune Most Admired) and add High Yield and Preferred Stocks to their mix. I have directed increasing amounts of money towards bonds from cash, but I am also inclined to keep cash levels fairly high.
I have regularly gotten questions about the appropriateness of gold and other commodities for client portfolios, particularly in light of the recent declines in oil. While commodities can perform well over shorter periods of time, their long-term trend in price, due primarily to technological innovation should be downward and this makes them a questionable long term investment. Historically, the primary justification for holding commodities is that that they are an excellent diversifier (they tend to go up as a result of things that drive stock prices down), but this has not been supported by recent events, and for this reason, I am reluctant to invest in any major way in these assets.
As we enter into this new year, I am generally optimistic about the potential for strong performance from most of the capital markets, and I expect positive returns for all types of clients. My concerns relate to the problems of inflation and long term government debt. Let's hope that the governments of the world do a better job of managing the stimulus package that is about to be injected in the economy than I and many others fear. Until long term macroeconomic stability emerges - particularly in the form of balanced budgets, positive savings rates and the absence of repeated massive injections of capital into the economy, my suspicion is that most risky assets will remain below their full potential.
By and large, trust appears to be returning and the capital markets repairing themselves. Most of the risky asset classes have appreciated significantly from lows established in November, with the notable exception of commodities. Most strikingly, corporate bonds by the higher rated issues appear to have fully recovered to pre-Lehman levels. High Yield ("Junk") bonds and preferred stocks have also staged impressive gains and, arguably, the credit crisis has ended. Equity markets remain mired at dismal (although higher) levels and are effectively as cheap as they have been since the 1970s- particularly in comparison to government bond yields. There remains strong expectation that corporate profits have declined and there is a lack of confidence in the accounting and financial projections of public firms, despite the intense regulation that has been imposed post Enron in the form of Sarbanes Oxley.
Stocks have always taken longer to recover from panics than other investments. This is because trust and confidence are much more easily destroyed than they are built. While the causes of the recent collapse in equity values were the product of an overreaction to what was happening in the real estate and banking sectors, what a rapidly reveals are the misrepresentations and outright fraud inherit in capitalism and an eternal component of Wall Street. Where confidence can be restored in the mortgage and bond markets relatively quickly - once investors keep getting their interest and principal payments they soon return to buying (particularly if the rate on cash is effectively negative), stocks require trust, confidence and faith in the future.
Recent events in the political space (Blagojevich) and financial (the recent revelations of corrupt practives at the rating agencies and Bernard Madoff) are part of why stocks will take a while to recover and while the riskiest stocks will probably be last to see significant capital appreciation. The quickest and most stark punishment of evil will have the best effect of repairing investor psyches in the short term, and thus the markets, but it is reasonable to expect that more ugliness and shame will appear in the headlines in the coming months, leading to volatile equity markets. And, rarely is the best solution for the short term, the best choice for the long term. Repairing the system that allowed for these abuses of trust to exist will require deliberation, debate and trial and error. There has been far too much seeking of a quick fix for our short term problems (like stimulus packages or the demand for a relaxing of accounting standards) at the cost of the long term stability (balancing federal and municipal budgets or encouraging Americans to return to long term savings strategies). Equities are a long term investment, and their performance is affected by long term trends.
This is not to say that current forces are not highly supportive of a near term equity rally. The ever expanding stimulus package proposed by the President and congressional leaders will likely stimulate great short term economic growth. Infrastructure investment, when properly spent, can have tremendous long term benefits to the aggregate economy. The national highway system, mass transit, the Internet and space exploration have all been government inspired infrustructure investments produced benefits far exceeding their cost. But the concern that I have is that in this environment of universal agreement that piling on more debts is the answer, cronyism and waste will likely result. The dominance of one political party (and yes, particularly the Democrats) doesn't help discourage me from this concern. I fear that massive "investments" will do little more than create long term problems of inflation and benefit obligations for newly created unionized laborers with little long term returns. There were several efforts to use the broadsword of government power to bring the economy out of recession in the early 1970s which probably made problems worse.
So, against this backdrop of uncertainty - what is one to do?
The answer is, I believe, very different depending upon a wide variety of circumstances (as it always is) and in each client's case, I am approaching the question of asset allocation and investment selection differently. While there are certain consistently logical approaches, such as maintaining exposure to blue chip, solid brand stocks (as represented by my Fortune Most Admired Companies strategy). However, I will discuss broadly my approch depending upon risk tolerance (remembering that each client is different):
For Aggressive investors, probably the most attractive equity investments remain US Large Growth companies, Emerging Markets and High Yield Bonds. I have generally been reluctant to enter back into emerging markets in a major way, but over the course of the next few months, I am increasingly interested in investing in this space. Emerging markets are currently very beaten up and the valuations look attractive, but this may be a several year story to work out. This is particularly true if oil remains at these depressed levels. Most emerging economies are heavily dependent upon resource intensive industries and this will likely have complicated and frequently conflicting economic and political impact. Broad diversification makes the most sense as a risk management strategy. But, for investors with patience and a long time horizon (20+ years), this seems like an obvious play given the eviceration of most emerging countries' equity markets over the last few months.
For Moderate investors, I am, and have been, adding Preferred Stocks, High Yield Bonds and Blue Chip stocks. High dividend yields are encouraging as has been strong support for the banks who are the primary issuers of preferreds. Given the unlikely event of significant calls of preferred or bond issues, this is particularly so. However, volatility is to be expected in the coming months, as more of the problems I alluded to emerge. I have also generally moved cash to bonds in these accounts, as I have been enticed by higher rates of interest than earlier last year and the capital gains that the recovery of bond and stock markets have delivered. I remain very concered about the potential problems that are likely to emerge within municipalities over the next few years, but I think that selective purchases in this space (coupled with a tolerance for volatility) may make sense - particularly in light of the effective total recovery of the corporate bond markets and what are now less attractive rates of interest. Inflation indexed bonds also make sense, as the likelihood of high inflation is considerably greater with all of this government debt issuance and the fact that investment markets seem to have completely ignored this possibility, pricing expected inflation at about 1% over the next few years.
For Conservative investors, well, this is a tough one. 2008 was a year of extreme volatility for "conservative investments" (bonds issued by banks, mortgage backed securities, inflation indexed bonds, etc.) Given the inherit reluctance of a conservative investors to take on risk, but balanced against the extreme attractiveness of risky assets, I am inclined to allocate equity money towards US Large Cap stocks (in particular the Fortune Most Admired) and add High Yield and Preferred Stocks to their mix. I have directed increasing amounts of money towards bonds from cash, but I am also inclined to keep cash levels fairly high.
I have regularly gotten questions about the appropriateness of gold and other commodities for client portfolios, particularly in light of the recent declines in oil. While commodities can perform well over shorter periods of time, their long-term trend in price, due primarily to technological innovation should be downward and this makes them a questionable long term investment. Historically, the primary justification for holding commodities is that that they are an excellent diversifier (they tend to go up as a result of things that drive stock prices down), but this has not been supported by recent events, and for this reason, I am reluctant to invest in any major way in these assets.
As we enter into this new year, I am generally optimistic about the potential for strong performance from most of the capital markets, and I expect positive returns for all types of clients. My concerns relate to the problems of inflation and long term government debt. Let's hope that the governments of the world do a better job of managing the stimulus package that is about to be injected in the economy than I and many others fear. Until long term macroeconomic stability emerges - particularly in the form of balanced budgets, positive savings rates and the absence of repeated massive injections of capital into the economy, my suspicion is that most risky assets will remain below their full potential.
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