“Yesterday, everybody smoked his last cigar, took his last drink and swore his last oath. Today, we are a pious and exemplary community. Thirty days from now, we shall have cast our reformation to the winds and gone to cutting our ancient shortcomings considerably shorter than ever.”
A New Year's Resolution
Congress ushered in the New Year with a resolution of its own, a vote many believe helped prevent an immediate recession that would have risen from the tax increases and dramatic spending cuts embedded in the much-discussed, closely-watched, and widely-publicized "fiscal cliff." As expected, it was an especially nasty series of political negotiations. Ironically, we might recall that the series of automatic spending cuts and tax increases emerged precisely as a result of a previous round of dysfunctional negotiations between the two parties in 2011—a grotesque construction of sorts by Congress itself as a testament of its inability to agree on just about anything. The combination of drastic measures was severe enough to make Congress look down over the proverbial cliff, and confront itself like a New Year dieter with a pounding hangover might look down at a growing midsection before swearing off cheesecake and vodka over the next 12 months.
Fortunately, perhaps, for the long-term well-being of the country, Congress' self-confrontation resulted in a series of tax increases aimed at reducing the deficit. That is to say, part of a long-term solution to fiscal responsibility may have been addressed. But in a way, the situation is like a dieter who trades cheesecake, hard alcohol and cigarettes for an all-doughnut-and-potato-chip diet while solemnly espousing the merits of drinking plenty of water, frequently napping, and going on an occasional walk. Of course, the economic situation is more nuanced but the point is the same: Congress may have only partially addressed a long-term solution to our country's fiscal situation. Let's consider the sheer size of the imbalance in more straightforward dollar amounts. Based on scaled-down estimates of 2012 spending and revenue from the non-partisan Congressional Budget Office's (CBO) most recent projections, the federal government is akin to an American family making somewhere around $24,000 a year, spending $35,000, and paying for the $11,000 deficit by adding to a credit card that already has a balance of $113,000. Moreover, this family has no plans to stop adding to its credit card at any point (the CBO's estimates stop at 2022), but just attempted to reduce the problem after asking for, and receiving, a $62 raise.
In fairness to Congress, policy-makers must achieve a difficult balancing act that families don't have to worry about: they must consider the level of spending, the level of taxation and the level of growth in the broader economy while balancing short-term economic growth and long-term solvency. As a result of this "economic balancing act" there are several policy mistakes that could occur, each of which could have adverse consequences. Increase taxes too rapidly or too high, and economic growth may suffer and result in fewer jobs. Tax too little and run the longer-term risk of not adequately reducing the level of federal debt. Spend too much and the long-term health prospects of the national balance sheet weaken because future generations must pay the debt back. Cut spending too rapidly, or spend too little, and run the risk of reduced growth or a possible recession.
Although encouraged by Congress' initial steps, we do not suspect that spending cuts were adequately addressed as part of the American Taxpayer Relief Act. It is likely that sometime during the first quarter of 2013, the federal government will once again be forced to confront the debt ceiling and an additional round of political negotiations are expected to take place around that time. Just as stocks fell as the fiscal cliff issue drew nearer, and also fell the last time that the federal debt limit arose as an issue, there is a possibility that equities may sell off when the federal debt limit again moves to the forefront. It is also worth noting that stocks resumed their upward movement after these issues were removed from the spotlight, regardless of whether or not investors viewed the issues as fully resolved.
2012 in Review
In 2012 we advocated a focus on managers who allocate heavily to high-quality, large-cap stocks, with a slight preference to those in the US. We focused on investing in a smaller proportion of smaller-sized companies, and we also introduced a modest shift away from foreign investments and reduced allocations to investments in Europe. It was a surprising year in some respects, and most of these decisions detracted slightly from performance relative to doing the opposite. These positions still made gains and the differences were modest when considering the size of the positioning in a well-diversified portfolio. For example, a focus away from smaller stocks in favor of larger ones was correct most of the year, but large caps began to underperform late in the year (the difference was around 0.33% for 2012). Another somewhat surprising development for 2012 was the performance gap between low-quality and high- quality stocks as classified by Standard & Poor's. Stocks with more stable earnings histories underperformed stocks with volatile earnings histories. Had we undertaken the opposite move, and allocated to managers with a low quality bias, we would have added a small degree of incremental performance to portfolios, but we remain committed to holding managers who invest in high-quality companies.
Looking to the Year Ahead
Looking ahead to 2013 we still have a high level of confidence in most of the investment themes currently in the portfolios and will continue to hold the best-regarded investment managers where they are appropriate. In some areas within the portfolios, we are actively debating possible changes, including the possibility of reducing U.S. exposure relative to foreign stocks, modestly reducing large cap stocks relative to mid-and-smaller stocks, and also reducing our relative overweight to non-Japan Asia within foreign stocks. At some point in the next 12-24 months, adding exposure back to managers who invest in European markets may become attractive for long-term investors and we are continuing to monitor the situation.
Currently, low yields on long duration bonds may translate into high levels of risk and limited potential for upside, and we are seeking to avoid as much interest rate risk as possible. Consequently, we will continue to maintain a significant short duration focus in most fixed income portfolios where appropriate. We continue to believe the role of fixed income should be, first and foremost, to provide the best protection that is reasonably possible against the permanent loss of capital. Unfortunately, due to bond mathematics, the historically low yields currently provided by bonds result in generationally high interest rate risk. Although there is no law of nature that prevents yields from remaining low for long periods of time, the capital losses that may occur if interest rates increase (as they have in the past) can be substantial for a portfolio that is supposed to be considered "safe." Even though low yields—especially for short maturities—are causing headaches for investors, there are areas where additional yield may be added to a portfolio. One of these is through the addition of global bonds, which may add diversification benefits while adding a degree of yield. A second way of adding yield is by adding a portion of corporate bonds of varying credit qualities that a competent bond manager is watching closely. Third, where our fixed income portfolios have short-duration managers, we have identified several strong managers who have historically been able to protect against losses and generate a moderate uptick in yield relative to other short-duration bond managers.
In the very near term, however, there are several economic tailwinds (some of which are highly positive) that are roughly equal to the often-cited headwinds associated with the current economic situation. Some of the tailwinds include corporate profitability reaching all-time highs, strong third quarter GDP growth, rising consumer confidence, improving balance sheets at banks, a strengthening housing market, and continued job creation. Also of interest in the near term, corporate balance sheets continue to hold historically high levels of cash. We believe that investors will eventually benefit as the historically high levels of cash are either returned to shareholders or re-invested by management teams. One of the ways corporate cash can be invested is through mergers and acquisitions. Research has indicated that strong commercial and industrial lending activity following economic shocks (such as the 2008 crisis) has historically preceded merger waves. During the third quarter, mergers and acquisitions reached post-crisis highs (deals amounted to $303 billion) amid post-recession highs in commercial and industrial loans outstanding at commercial banks. If the research is correct, the combination of events may bode well for a few select active managers.
Over the short term, we encourage investors to consider the strength of the stock market rally of the past several years. From 2009-2012, the S&P 500 has gained a cumulative 72% when taking dividends into consideration. For the S&P 500, this is a 4-year gain that is stronger than 64% of 4-year-gains since 1926. This strong stock performance is an important backdrop, and we encourage investors to consider the possibility of a double-digit correction given the size of the post-2008-crisis rally. A correction of about 20% has been a typical level in the past, even in long-term bull markets. If you anticipate the need to access your equity holdings over a shorter time period or if you believe that a 20% (or potentially larger) correction would not be tolerable, we encourage you to reach out to discuss investment goals and a more appropriate asset allocation.
For investors who do not require access to the funds in their equity positions for 7-10 years or more, we continue to believe that remaining invested in the equity markets will provide our managers sufficient ability to capitalize on several long-term trends that are emerging. Over the longer term, we believe tailwinds such as the potential for substantial increases in shale oil and natural gas production in the U.S., significant future growth of emerging markets, and a possible resurgence in American manufacturing may reward investors who are able to remain patient during volatile periods. As always, we welcome the opportunity for a discussion. Should you have any questions or concerns, please call us at (503)597-1600.
Heintzberger | Payne Advisors
December 31, 2012
Past performance is no guarantee of future results. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Opinions are subject to change without notice. Heintzberger | Payne Advisors ©2012