It has been a long, cold and dark winter for investors. However, starting March 9, all of the major stock market indices rallied by 20 percent or more, before abruptly correcting shortly after.
This advance has been amazingly swift and powerful. Some commentators have said the rally should be used as an opportunity to lighten up on stocks. Others disagree and believe that the bottom has been reached and it is time to get more aggressive. So what is an investor supposed to do?
The reality is that there is no way to know for sure if we have seen the ultimate market low or not. Therefore, we believe this is the wrong question to ask.
Let’s begin by looking back at the Internet bubble that occurred in 2000. During that period, stocks were vilified and alternative asset classes were the investments to own. Hedge funds, real estate and private equity managers were the “smart money,” and it was believed that they could earn solid absolute returns in any type of market environment.
Unfortunately, this has not held true during the current malaise for most investors. It is not because these managers have suddenly become the “stupid money.” Rather, when too many investors utilize the same strategy and hold the same beliefs, assets prices become overpriced. No asset class is exempt from investor overconfidence.
So with the benefit of hindsight, what did investors get wrong this time? Our country and indeed the entire world became too dependent upon leverage. Many demanded greater growth and higher returns. Perceptions of risk became distorted. While not everyone used excessive leverage, most benefited, at least indirectly, from the increased business activity that occurred. The excess liquidity helped fuel a long cycle of prosperity. The wealth that had been created, however, was ephemeral, and we are now dealing with the consequences. In the future, growth will be harder to achieve.
This might lead some to believe that going forward, bonds will be a better investment than stocks. In fact, many commentators are now espousing the virtues of bonds. They are showing long-term charts that illustrate similar or even greater returns were earned by investing in bonds, certificates of deposit, or even treasury bills, with a much lower level of risk. This has led some to argue that stocks are too speculative to be an appropriate part of an investment portfolio for many investors.
We do not agree. We look at the world from a bottom-up perspective, versus a top-down macro view. We feel it is important to remember that when people talk in generalities, they tend to oversimplify. Statements like “Stocks did poorly or well” can be misleading. We would like to remind you that many value investors actually did quite well in stocks in 2000 and 2001. With respect to stocks, we believe this means focusing on quality firms that produce products or services that people are willing to buy.
We want to own companies that are gaining market share and have the ability to remain profitable in difficult times. With respect to bonds, credit spreads are currently predicting the bonds will experience the highest default ratio since the Great Depression. We want to own bonds that have a margin of safety, which leads us to believe we will not only get our interest but also our principal back. There is a great deal of uncertainty today for all investments.
Although we do not know if stocks or bonds will outperform over the next year or two, we know that diversification remains important. All types of investments have risk. However, these risks have different consequences. The risk may be the loss of principal, purchasing power, or opportunity cost. Therefore, we believe the question investors need to be asking is, what risks are they taking and are they comfortable with those risks? Some investors may have been too enamored with higher risk assets in search of greater returns and should use this opportunity to become more conservative. However, for many, that could be the wrong decision.
For example, the conservative Texas Municipal Retirement System was down only -1.3 percent last year when many savvy investors like the Harvard Endowment were -25.0 percent or more. You would think they would be satisfied with this limited loss and be pleased that they were invested solely in bonds.
In fact, they have recently decided to diversify their portfolio and start buying stocks. They made this decision because, as they look forward, they have determined that they cannot earn enough in bonds at current yields to meet their liabilities. There is a cost and a benefit to every decision. They have determined that if they do not diversify, they will need to increase taxes or spend less on other government services.
We have been saying repeatedly that we are not yet ready to reallocate more money to stocks. However, we know the time is coming in the not-too-distant future when, for many, this may be the right decision. We have also been saying that asset allocation goals need to be revisited. Two major market declines in a decade have created an environment where everyone is more aware of risk than we were during the 1980s and 1990s.
We believe that now is the time to be thinking hard about long-term goals.
Scott Wagasky is a principal and director of business development for AMBS Investment Counsel LLC, Grand Rapids.