Economic and Investment Review

Transcript:

Thank you so much for taking the time to join me for our mid-year economic and investment review. We have a good crowd here, and even more that couldn’t join us. So I’ll be recording this and will have the replay available at our website shortly.

This is an entirely new communication tool for Precedent Asset Management, so in addition to the fact that you’ve taken the time to watch, I would greatly appreciate any feedback you have on the format and technology. I want this to be incredibly relevant and useful for you.

In the next 15 minutes, I’m going to cover two of the more significant economic and market events of the first half of the year, how those have impacted investment returns, and then our portfolio positioning as we look forward.

This first significant economic event is Gross Domestic Product, or “GDP”, which has made headlines three times so far this year. This is the measure of how much the economy is growing or declining. This chart shows the last two years of growth each quarter.

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In April, it was announced that the economy barely grew during the first quarter – up only 0.1%. You may recall a lot of media discussion about how the bad weather in January was to blame for the lack of growth. Then in May, the number was revised to reveal that the economy actually declined by 1.0%. This was a pretty significant revision to the first estimate, and the pundits lit up with reminders of exactly how bad those snow storms were in January. By the time the final data was all in on June 30th, we learned that in reality the economy fell a stunning 2.9% — one of the worst declines in history. And it wasn’t just the weather. If you’re curious, the data showed that a big part of the decline was a decrease in health care spending (that sounds like a good thing to me).

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What you’re looking at now is a ranking of the worst 25 declines in economic growth for the US, where the first quarter of 2014 ranks 17th. Out of morbid curiosity, myself and a few colleagues wanted to know what typically happens next after these 25 worst declines. And as you can see, in every single instance the US economy fell into a recession. While that’s certainly interesting, that doesn’t mean it will happen this time. Most economists are predicting that the second quarter GDP this year will report growth between 2.3% and 4%, which would mean we are not in a recession – unlike ever other similar event in history. On July 30th the first official estimate will be released, and we’ll see what actually happened after the second and final revisions in August and September.

So a big decline in GDP and possibly a recession – that’s bad right? The media is going to tell us the sky is falling. Well, we’re still curious, so we added a column to the data examining what the US stock market did after each of these 25 worst declines in history, and were a little surprised by the result. In all but 4 instances, the stock market went up, and significantly. The sky didn’t fall. So far, the market has returned 5.23% since the 17th worst GDP decline – we’ll see what the rest of the year has in store.

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A two variable analysis like this is far too weak to be predictive, and the stock market is currently at the highest valuation of all these prior instances, making gains harder to come by. So this is going to be an interesting time in investment history.

The second significant market event is that interest rates have resumed their long-term decline.

You may recall from my July 1st market update email that 20+ year US Treasury bonds were one of the best performing assets for the first half of the year – up 13.19%. When interest rates fall, you make money in bonds. And the graph you are looking at now shows the steady march lower in US interest rates over the past twenty. At the tail end, you can see the sharp downturn in interest rates year-to-date, after last year’s rebound. Depending on a client’s objectives, we currently own between 40% and 60% of our portfolios in bonds, and this is why. In the current economic environment, a diversified portfolio with exposure to conservative bond investments achieves returns sufficient to meet investor objectives without subjecting the portfolio to the real risk of a 30% or greater loss of wealth due to a decline in the stock market.

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But what about the “Bond Bubble”? Since about 2008 I have consistently heard that interest rates are on the verge of spiking higher, and that there simply isn’t any room for them to go lower. But for reasons that are evident in current economic conditions, the opposite has happened. Rates continued to go lower and bond returns remain high.

So how about now? Are we finally at a point where there is nowhere to go but up? Is there a bond bubble now? Let’s see how interest rates in the US compare to interest rates in other countries. There are many countries with interest rates higher than ours; but is it possible to go lower? US 10-year rates are currently 2.53%. Germany is 1.19%. Canada 2.21%. Japan 0.54%. Switzerland 0.60%. And a few others that are of interest.

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Just like the stock market doesn’t crash just because it has gone up significantly, or just because we had a really bad GDP decline, interest rates aren’t going to up dramatically just because they are at low levels, or just because the government is borrowing a lot of money. There are much more complex economic and market factors at play, and we are working very hard to understand these and then to structure our portfolios in a way that will achieve your long-term objectives without exposing you to excessive risks.

This concept of achieving superior long-term returns by avoiding large losses was explained in a research article published by the Journal of Financial Planning last September. In mid-September, I sent out a client letter summarizing the research. If you haven’t seen it, let me know and I’ll send you a link — Why Risk Matters. It’s a very important piece that drives how we manage money. The summary is pretty simple – slow and steady wins the race.

With that in mind, let’s take a look at our two core investment models year-to-date.

The green line on the chart you are looking at shows the growth path of our Moderate model, compared to the US stock market represented by the thin line. The Moderate model earned 4.77% during the first 6 months of the year, with current stock exposure of only 38%, versus the broad US stock market return of 6.10%. As you can clearly see in this chart, we barely participated in the market sell-offs that occurred in January and early April. And it wasn’t until the last 30 days or so of the period that the market caught back up and passed our slow-and-steady portfolio. With our investment process, every market sell-off presents opportunity, and I look forward to the next one.

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The Moderate Growth model had similar results but with current stock exposure of 48%. This model earned 5.08% for the first half of 2014, but only participated in 1/3 of the market’s downside.

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I have clients with more aggressive and more conservative investment strategies, but these two models cover that vast majority of the assets I manage. The quarterly performance reports that are being mailed out this week will provide the calculated return of each of your specific accounts and unique strategies.

Alright. Now let’s take a quick look forward and talk about 2 things that are driving some of the more significant changes in our investment strategies. Reaching for yield, and home bias.

Reaching for yield is an investment behavior that occurs when someone becomes dissatisfied with the interest earned on safe assets and begins to buy riskier assets in order to get a higher yield. It is most likely to happen when interest rates are at very low levels – like today.

The more investors buy higher yield, higher risk investments in order to improve their interest income, the less attractive the investments become.

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A significant component of our investment strategy since the 2008 credit crisis has been high yield bonds – an asset class that has delivered returns of over 12% per year for the past 5 years. Today however, these bonds are only yielding a little over 5% in interest. Now that sounds okay, and it’s why a lot of investors are buying these bonds. But the average default rate is about 4% historically. So after accounting for defaults, investors can only expect a net return of 1% — less than the current yield of risk-free government bonds, and with dramatically more price volatility. That doesn’t sound like a good deal to me anymore, and we have already begun the process of reducing our allocation to high yield bonds in favor of lower-risk asset classes.

Home bias is an investment behavior that causes someone to overweight a particular region of the world in their investment portfolio for no good reason other than that’s where they live. North Americans on average invest 75% of their assets in North America, Europeans invest 61% of their assets in Europe, and Asians invest 84% of their assets in Asia. I think that sounds very natural, but I also know there are better ways to make these investment decisions.

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The United States makes up 48% of the global stock market and is currently the second most expensive developed country to invest in behind Denmark. This chart shows the US stock market valuation compared with other developed countries. Knowing this, we don’t believe that allocating 75% of an investor’s stock exposure to the US makes sense presently. We have already begun the process of reducing our US allocation to a neutral weighting as we find better investment opportunities in companies around the world.

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Now that we’ve covered the economic highlights, investment performance, and portfolio positioning for the second half of the year, I want to thank you for taking the time to join me today. Please send your questions and feedback to me by email, and watch for a replay link and transcript to be made available as soon as possible. Thank you, and have a great week!