On average our model portfolios performed on par with their respective target date benchmarks during the last quarter. Yet around that average performance there was a good deal of variance…so your plan’s models may have under-performed, outperformed, or just kept pace with their Vanguard Target Date comparisons.
We suspect 2014’s 1st was a quarter that will quickly be forgotten – not only for its mediocre returns but for its seeming blandness and the public’s general apathy towards pretty much everything – from Obamacare to the annexation of Crimea; people just don’t seem to care. And when the public becomes indifferent, or even complacent, that’s usually a time for concern.
While voices extolling the virtues of passive approaches to investing seem to grow louder each day, we expect that the next decade will be exceptional not for those focused on paying the lowest fees for an indexed strategy, but for those able to better manage a more hostile environment of increasing volatility, lower liquidity and choppy returns.
Going forward: watch corporate pre-tax operating margins
Corporate pre-tax operating margins are our “canary in the coalmine”. They’re where the first signs of “market stress” are likely to be found going forward and are likely to foreshadow the next big market meltdown.
On whole, U.S-based companies have become very adept at managing earnings growth through share repurchases and the clever use of debt over the past few years. They’ve had a lot of internal flexibility to offset sub-par external demand. The net result is less volatility in reported earnings growth, expected future growth, and stock prices than might otherwise be the case.
Yet, seemingly unrecognized by the mainstream media and analyst community, the elevated corporate pre-tax operating margins that have allowed for corporate internal flexibility are an indirect result of Federal Reserve intervention.
As the Fed slowly steps away from intervention, corporate profit margins will contract and interest rates rise - likely constraining corporate flexibility, leading to more volatile earnings, and likely subjecting stock valuations to downward revision.
Just a little something we’re keeping an eye on.
Our thematic views & their resulting investment implications
We believe stocks remain over-valued and over-extended in the U.S. and relatively under-valued in both international developed and emerging markets (but facing stiffer macro-economic headwinds). Hard to believe, but at little more than 3 to 4% yields, fixed income assets may well prove better investments than stocks over the coming decade.
I. U.S. stocks, fully valued, face a challenging environment.
Federal Reserve intervention has been the key catalyst for asset appreciation for the past few years, and is now in the process of being “un-wound” by about $10 billion per month. This, coupled with nearly stagnant organic earnings growth (that achieved through sales growth, not share buy-backs), puts U.S. stocks in a precarious position.
Valuations when adjusted for historically high operating margins, are not cheap - and haven’t been for quite some time. In fact by historically reliable metrics, U.S. stocks look set to deliver no more than 2.5% annually for the next 10 years.
In the face of an economy that remains sluggish at best, the IPO window is wide open, and recent offerings have taken on a more exuberant, though not yet manic, tone. This is a movie we’ve seen before – it doesn’t end well.
II. Drop down a risk level.
Our work continues to suggest that over the next 10 years our aggressive models will likely out-perform our conservative models by no more than 0.25% annually – if at all. That’s not nearly enough incremental return to justify taking on an increased potential drawdown of 20% or more.
There are times to be fully in the market, and times to watch from the sidelines. Now is the time to be scaling back. Instead of aligning yourself with our aggressive model, switch to the moderate or conservative alternatives instead. There will be better opportunities to get more aggressive, and we’ll let you know as they arrive.
III. A further rotation into value (away from growth) in the U.S.
Our models are more heavily biased towards value over growth this quarter – a tilt that paid off modestly in Q1. While the world seems truly starved for the growth associated with companies like Google, Facebook, and Amazon, valuations are simply too rich at present. Instead we’ll focus on the beaten down natural resource cyclicals, attractively priced healthcare and more speculative financial institutions that comprise the value sectors. BTW, believe it or not, Apple and Cisco now part of some U.S. large cap value indices. How times change.
IV. Adding modestly to international stock positions.
Overseas markets are cheap relative to their U.S. counter-parts. But they face harsher headwinds from a stagnant global economy due to their heavy dependence on natural resource-based exports. That said, valuation differentials with U.S companies are now large enough to take modestly increased positions across our models.
V. Believe it or not, bonds returns are likely to remain competitive.
We’ve recommended against holding U.S. treasuries over the past couple of years as their ridiculously low yields have unwaveringly pushed us towards spread sectors – mortgages, high-yield corporates, etc. Well, that bias has paid off as over the past couple of years – so much so that the relative reward for holding credit sensitive bonds is now fairly limited. We suspect our models will now begin taking increased exposure in treasuries.