3rd Quarter Client Note

What goes up must come down. I always attributed that idiom to Blood, Sweat & Tears and their 1969 hit song, Spinning Wheel (which peaked at No. 2 before it came down.) But apparently the real author is Sir Isaac Newton back in the 17th Century. Go figure. But with the post 2008 bull market going on five and a half years now, it’s not surprising that equity markets may be flirting with a correction.

While the S & P 500 (total return) Index eked out a 1.13% return, the rest of the Morningstar style box was negative. The average domestic stock fund was down 1.92%. The Russell 1000 Value Index was down 0.19% and the Russell 2000 (small cap) Index lost 7.36%. International markets fared no better. The MSCI World ex USA Index fell 5.74%. And the Emerging Markets Index went down 3.5%. Both commodities and real estate suffered significant losses as well.

Fixed income experienced a fractional gain, with the Barclays US Aggregate Bond Index up 0.17%

Consequently, broadly diversified portfolios lost ground in the quarter. The Dow Jones Moderate Global (Asset Allocation) Index came in at negative 2.13%.

Just a Preview?

The real action, however, started at the beginning of the fourth quarter. The week of October 6 was one of the most volatile in a while – with the Dow Jones Industrial Average having moves of nearly 300 points on three consecutive days – ending the week down 466 points (2.7%) and in negative territory for the year. And the selling has carried over into this week as well.

With the stock market on a five-year run, fears of a global economic slowdown have some investors on edge. Even with interest rates being kept at historic lows, some economists are worrying about deflation. Oil prices are at a four-year low at around $85 per barrel.

Still, this kind of short term volatility is closer to normal than what we’ve been experiencing lately. The S & P 500 Index had gone more than 60 trading days without a daily 1% move – the longest such stretch since 1995. Even in bull markets (loosely defined as going up steadily without a 20% decrease), the market has frequent “corrections” of 5 – 10%, often lasting for a month or two.

The Real Challenge

Short term volatility is really the last thing investors should be worried about. Investors should take exposure to the equity markets because they need – or strongly desire – returns that are higher than available in safe investments – like Treasury bills. And only in order to achieve their long term financial goals.  Investors who strategically structure their portfolios over their lifetimes are attempting to capture the so-called “risk premium” – the difference between the returns to Treasury bills and to stocks which has historically been available to patient investors.

But they don’t call it the risk premium for nothing. As our friend Larry Swedroe points out in this recent article (which I encourage every investor to read and understand), capturing the risk premium for stocks (which has amounted to a hefty 8.18% over the period from 1927 – 2013) requires extraordinary fortitude, patience and behavioral control. And that is because the premium is extremely volatile on an annual basis (negative 32% of the time) – and even on a five or ten year basis. In fact, even over a 25-year investing time horizon, there is a 5% chance the premium won’t be realized.

Gross Me Out

Among the noteworthy news stories in the third quarter was the abrupt – but not altogether surprising – departure of “Bond King” Bill Gross from Pacific Investment Management Co. (PIMCO) to the Denver based – and relatively tiny – Janus Capital Group.

Over four decades Gross had built PIMCO into a fixed income powerhouse ($2 trillion in assets) via its flagship PIMCO Total Return Fund. Until recently, Total Return had an enviable record of fairly consistently – and at times handily – outperforming its benchmark, the Barclays US Aggregate Bond Index. Total Return has been a wildly popular – and sometimes sole – fixed income choice in 401(k) plans.

But Total Return had underperformed of late and has been losing market share amidst investor outflows for the past year. Moreover, Gross’ heir apparent, Mohamed El Arian, left PIMCO after a falling out with Gross. Finally, the SEC is investigating whether PIMCO “artificially boosted the returns” of the ETF version of Total Return (BOND) by inaccurately pricing some thinly traded securities in its portfolio; thereby giving the appearance of higher returns. The investigation is ongoing.

A Peek Behind the Curtain

PIMCO Total Return has always been something of a black box, making it inscrutably difficult to understand the source of its outperformance. Gross has often employed options and derivatives – on top of simple bond ownership – adding leverage to enhance the returns in its portfolio; a tactic that works well in the kind of falling interest rate environment we’ve experienced for the past 30 years or so. The fund has also often contained securities not included in its benchmark, such as foreign bonds. Its complete list of holdings extends to hundreds of pages.

More power to Mr. Gross – and other “star managers” like him. But we would rather take our risk exposure on the equity side of the portfolio where it belongs. Bonds are there as ballast to your portfolio – to reduce overall volatility, to help you sleep at night and to provide liquidity during times of economic distress, like 2008. On that score we generally prefer plain vanilla bond funds that are transparently true to their charters and more easily and reliably slotted into an asset allocation.

CAPE Crusader to the Rescue?

Why don’t I just get out of the market when it’s going down and get back in when it’s going up? A simple trading rule accomplishing just that is the investor’s Holy Grail. If only it were that easy.

One potential method has received a great deal of press lately – the Cyclically Adjusted Price/Earnings (CAPE) ratio developed by one of last year’s Nobel Prize winners, Professor Robert Shiller of Yale. A stock’s – or the market’s – price earnings ratio is a well-accepted measure of valuation. When the price is high in relation to earnings, stocks are considered to be expensive and vice versa. This valuation normally compares price with a static earnings amount; last year’s, this years or projected next years.

The CAPE ratio takes an average of earnings over ten years (thereby smoothing the denominator) and seeks to evaluate whether the market is over-valued or under-valued compared with the average.  According to Shiller, the CAPE has ranged from a low of 5.57 in 1932 to a high of 44.20 in 1999. The average is 17.54 and today is in the mid -20’s.

The newest edition of the Quarterly Market Review from Dimensional Fund Advisors discusses how difficult it would be to actually use this data to successfully inform a trading rule and concludes, “For those seeking the highest probability of a successful investment experience, maintaining a consistent allocation strategy is likely to be the sounder choice.” In the absence of a significant change in your individual circumstances, such as your spending requirements or your investment time horizon, we agree.

And, in any event, systematic rebalancing of a strategically balanced portfolio will take advantage of this phenomenon automatically. As prices of stocks rise – together with their P/E’s – that portion of your portfolio will become over-weighted and sold off to invest elsewhere. And cash flows will be directed away from the more highly valued asset classes and into those that haven’t performed as well. Simple – or at least simpler than trying to time the market – but not easy.

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