Dear Clients and Friends,
Last quarter I highlighted two services available to you at no charge, shredding and notary public. This quarter I am excited to introduce a new service which I believe can make a significant impact on your financial health.
In the last week of June we launched new software with tremendous functionality. As a client, one of the best features is that it acts as a data aggregator. We create a private, secure website for you. When you log in the first time all of the accounts we manage for you will be there and are updated continuously. You can add in other accounts we do not manage for you; bank accounts, credit cards, mortgages. Basically, you can add about anything you have online access to.
This allows you to have a clear understanding of your current financial situation and it provides me with a complete set of data to integrate into your financial plan. After a plan is developed, the system will alert both of us if we stray off too far from the plan. The system even provides budgeting features, can track your awards programs such as credit card points or frequent flyer miles, and provides a safe place to store and share digital documents.
Yet to come this month is an entirely new website, www.dvfin.com, built around the new system. For the time being, the new website is live but only has a short two minute movie showcasing the system and place for clients to login. Please visit the site and watch the movie. We would love to hear your feedback. Let me know if you would like to start using the new system and we will get you started.
Stocks or Bonds: The lesser of two evils?
The first half of 2012 was a tale of two quarters. The first quarter represented the strongest start for the U.S. stock market since 1998, the second quarter gave back some of those gains. Many investors feel as if they are facing a range of unattractive choices. Stocks appear dangerous and bonds yields are unattractive.
The second quarter saw volatility well above historical norms. Holding stocks has always been risky if your time frame is short, but geopolitical uncertainty and market swings make owning stocks feel especially dangerous today.
There is considerable debate about whether stocks are expensive, cheap, or fairly valued. Some observers express doubts about the sustainability of today's record corporate profit margins and the enduring impact of debt problems and slow growth around the world. U.S. stocks also show up on the pricey side using models such as the valuation approach advocated by Yale's Robert Shiller, comparing stock prices to average earnings over the past 10 years, adjusted for inflation.
On the other side, a fair number of reputable analysts view stocks as historically cheap, pointing to attractive ratios of stock prices to book values and measures like multiples of earnings and cash flows. Indeed, using Shiller's multiple of average 10-year earnings, Europe is inexpensive by historical standards.
Bonds pose different risks. Interest rates are historically low as central banks around the world keep interest rates down to spur economic growth. Given current inflation, in normal times we would expect to see interest rates about 2% higher than today, but of course these are not normal times.
Holding cash to eliminate risk from stocks and bonds virtually guarantees depreciation of purchasing power, and for many investors, cash gives them no chance of earning the returns they need to achieve their long-term goals.
Dan Fuss: Replace market risk with company risk
Dan Fuss is vice chairman of Boston-based Loomis, Sayles & Co. With over 50 years of fixed income experience, he is one of the most highly regarded bond managers of all time. Still actively running money in his mid-70s, Fuss manages a bond portfolio with over $20 billion in assets that over the past 20 years has been a top performer in its category.
In an April interview with Investment News, Fuss made an unusual recommendation for a bond manager: to sell bonds and buy stocks. The reason relates to the risk of rising interest rates. "We're in the foothills of a gradual rise in interest rates," he said. "Once they start to rise, you're probably looking at a 20- or 30-year secular trend of rising interest rates."
He went on to say that when the unemployment rate falls to between 6% and 7%, it's likely that Ben Bernanke and the Federal Reserve Board will alter the policy that has been keeping the interest rate on the 10-year Treasury bill artificially low. "Once that happens, you need to get out of the market risk that's in fixed income and into the company-specific risk you can find in stocks," Fuss said.
Bob Farrell: Market rules to remember
In the 1950s, Bob Farrell attended the same Masters program at Columbia as Warren Buffett studying under Benjamin Graham, the father of value investing. In 1957, Farrell joined Merrill Lynch as an analyst and retired as their Chief Investment Strategist in 1992, although he continues to provide his perspectives through articles and media interviews.
In 1992, Farrell penned 10 rules on investing. Of course there are no hard-and-fast investment rules which can predict what the market will do in the near-term or long-term, but two of those 10 rules are particularly pertinent today and give me encouragement about stock returns in the mid- and long-term period ahead.
Rule 1: Markets return to the mean over time
"Returning to the mean" is another way of saying that over time, performance on stocks will revert to historical averages. The long-term annual return in the U.S. stock market going back to 1926 is 9.8% before inflation and 6.6% after inflation, also known as the real return. Whenever you have an extended period in which returns exceed the long-term average, chances are a period of underperformance will follow. The opposite applies as well; a long period of underperformance will be followed by a period of above-average returns.
The 1990s saw average real returns of 14.9% annually, the best decade on record. Then reversion to the mean kicked in, and the following 10 years saw an average annual loss after inflation of 3.4%. Add the two decades together and you get a real return that's 1% below the long-term average. In essence, it's taken the last decade to rectify the valuation excesses of the previous 10 years—but with that behind us, history (and Bob Farrell's rule on reversion) suggest that long-term real returns going forward should be closer to the 6.5% average.
Rule 5: The public buys the most at the top and the least at the bottom
Since the financial crisis, total assets in U.S. fixed-income funds have more than doubled to over $2 trillion, up from $1 trillion at the start of 2008. At the same time, we've seen record outflows from U.S. equity funds. To me, this is further indication that, provided you have a time frame of five-plus years and can tolerate the kind of volatility we've seen of late, investing in a well selected stock portfolio is likely to serve you well.
Benjamin Graham, the Columbia professor mentioned earlier under whom Bob Farrell and Warren Buffett studied, gave this advice in 1963:
"In my nearly 50 years of experience on Wall Street, I've found that I know less and less about what the stock market is going to do, but I know more and more about what investors ought to do…. My suggestion is that the minimum amount [of the investor's] portfolio held in common stocks be 25% and that the maximum be 75%. Consequently the maximum amount held in bonds would be 75% and the minimum 25%…any variations should be clearly based on value considerations."
Today I would add a third asset category to the mix, alternative investments. I believe the Benjamin Graham's message from 1963 is not so much about the allocation percentages, but more about diversification. He taught us to neither commit fully nor to abandon any asset class, but instead to remain flexible and constantly seek value.
Given stock valuations and the risk in bonds, for some clients we have recently increased equity weights to the upper end of their range. Of course, market reversals from current levels are always possible; however, taking a long-term view, at current levels there is a strong case for stocks over bonds.
In an uncertain environment for immediate economic growth and equity returns, we continue to place priority on the cash yield from investments. While not suitable for all investors, the returns on some REITs, master limited partnerships, investment-grade corporate bonds, the better-rated high-yield bonds and dividend stocks in selective sectors continue to make these attractive relative to the available alternatives.
As always, thank you for your trust and confidence. Whenever you have questions, I am happy to take your call or meet with your personally. Be sure to let me know what you think of the new system, and in the meantime you can follow us on facebook.com/dvfin for more information.
Art Dinkin, CFP®