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1st Qtr 2013 Investment Review

What Now for U.S. Stocks?

With U.S. stocks hitting new highs, we are naturally getting asked two basic questions:

  1. With stocks up so much, should we anticipate a correction and lock in gains? (given all of the "big picture" risks)?
  2. With stocks up so much, should we increase our exposure and get rid of low returning bonds? (since the economy must be much better than people expected)?

Our short answer to both questions right now is, no. Overall our outlook for U.S. stocks has not improved, and, if anything, given the sharp run-up in stock prices, which implies lower future returns over our five-year tactical horizon, we are getting closer to reducing our U.S. equity exposure than we are to increasing it. But let me address the above questions in order:

1) Regarding anticipating correction, as we have discussed many times, we believe that a correction of 10% or more can happen at any given time for any given reason. Today, as in most times, we can see many things that could create some type of correction. Some examples of this would be the Fed suddenly changing their policies, a banking crisis in Europe, or political tensions around the world from the Middle East to North Korea; any of which could cause a correction in the U.S. However, history also tells us that we can go a long time without any significant corrections at all. In the 1990s, we went 8 years with no correction of 10% or more. We do not know what will cause the next correction or when it will happen-and neither does anyone else. That is the primary reason why we do not make adjustments in our allocations based upon the fear of a potential correction.

2) Should we increase our allocation to stocks given that they are doing so well? That goes back the level of risk you are willing to assume in your portfolio, otherwise known as your risk tolerance. In other words, how much risk will allow you to reach your goals while also not disrupting your "sleep at night" factor. When we have discussions on risk and asset allocation, the decision has nothing to do with the market. The market should not change your risk tolerance; instead, the markets determine how we manage a portfolio based on your risk tolerance. At the end of the day, if bad things happen and stock markets tumble, your best defense is high quality bonds - even with a 2% yield on the 10-year treasury.

So given the current environment we are in, what do we do? To some extent, we simply hedge our bets, within the context of your overall risk profile. This is simply diversification in action and is the prudent course in an environment this uncertain. We believe this approach should allow us to perform reasonably well across a wide range of potential economic outcomes, any one of which has reasonable odds of actually playing out. Making a big bet on an outcome that can't be determined with confidence is not in the best interests of our clients.

The Environment: Policy Uncertainty and Modestly Improving Economic Fundamentals

Government policy, both fiscal and monetary, is again a major contributor to the uncertainty that we face in today's environment. With respect to fiscal policy, in the first quarter the markets digested the "sequester" without much drama. However, the sequester's impact (estimated at around a 0.6% hit to GDP growth in 2013) is small potatoes compared to the debt and fiscal policy challenges that still confront the nation. Although we would agree that there is not an immediate federal debt crisis, there is clearly a growing deficit problem in terms of the medium to longer term timeframe. Even though lately we can detect the faintest whiff in Washington of an effort to address this issue, only time will tell if they will actually do so. Should policy makers find a viable path towards closing the deficit, it (obviously) would be a strong tail-wind for the markets.

On the monetary policy side, there is more clarity at least in terms of the policies already in place. The Fed continues to be very vocal that it is not close to unwinding QE, much less raising interest rates. Of course, there is significant uncertainty as to the longer term ramifications of these policies and whether or not the Fed's ultimate exit plan will be executed successfully. Most, including us, are skeptical.

In the meantime, Fed statements and actions continue to be an important support and driver of short-term stock market performance. While central bank actions have always influenced the stock market, the markets appear particularly attuned to and reliant on ongoing highly accommodative Fed policy. Again, over the near term, we don't see any catalyst for Fed policy to become restrictive. So that leg of support to the markets is likely to remain in place, at least for now. But the uncertainty increases as the time horizon extends.

Supported by accommodative monetary policy, U.S. economic fundamentals have continued to grudgingly improve. The unemployment rate continues to fall slowly-although that's partly driven by a particularly sharp drop in the labor force participation rate (meaning there are fewer people working or seeking work.) The housing market is strengthening (although mortgage lending to households remains tight) and household wealth is growing (driven by stock market and housing price gains), which is a key goal of the Fed's QE program. Finally, corporate earnings and profitability are around their all-time highs. However, our concerns about the impact of global debt deleveraging on economic growth and corporate profits remain.

Outlook for U.S. and Foreign Stocks

When I started in this business in 1985, foreign stocks were not something that were a significant piece of most client's portfolios. However, somewhere in the 1990s it became standard industry practice to allocate about 20% of a portfolio internationally, and today the perception of international stocks as a part of a portfolio is much more widely accepted. As time has passed, it seems that the "recommended" allocation has gradually increased, and, anecdotally, I would estimate the average allocation for investment firms today is probably somewhere closer to 30-40%. Over the last four years, we have held a significantly smaller allocation than that, which has helped our returns since the U.S. has significantly outperformed the international markets over that timeframe. As the returns of U.S. and international markets continue to diverge, it is becoming more likely that we will rebalance our portfolios to a more "traditional" allocation.

Update on Bond Markets and Fixed-Income Positioning

The big picture bottom line is that the fixed income marketplace, particularly the highest quality parts, continues to offer paltry longer term returns. Most areas of fixed income are trading at historically elevated prices, and yield levels are at or near historic lows.

What this means in terms of our fixed income positioning is that our balanced portfolios remain heavily underweight to core investment grade bond funds, at slightly under half of our strategic target weighting. In their place we have allocations to flexible and absolute return oriented bond funds that we expect will outperform the core bond index (Barclays Aggregate) across our five year scenarios.

Concluding Comments

Investing is a marathon, not a sprint. The key is to maintain discipline. We can analyze the longer term with far greater confidence, and invest accordingly, but realizing the benefits demands the discipline to ignore inevitable shorter term gyrations that are impossible to predict with consistency. Succumbing to the temptation to jump into "what's working" based on a recent run of outperformance is a path to disappointment and sub-par long-term investment results.


Jon P. Houk, CFP(NYSE:R)

This investment commentary is adapted from our quarterly client newsletter, and is reprinted here for informational purposes only. Nothing herein is intended to be construed as investment advice.