Investing for the Long Uncertainty AheadDavid Bogoslaw
Economists are characterizing the current financial crisis as everything from the Great Recession to possibly something on the scale of the Great Depression of the 1930s. Just how long will the pain and uncertainty last? Nobody knows. With the jobless rate expected to keep climbing, consumer spending, a key prop of the U.S. economy, may not rebound anytime soon. Meanwhile, Washington has yet to articulate a viable solution to the banking morass. That makes the odds for a recovery within the year or even the next two look worse with each passing day.
The implications for when and how investors can start to rebuild their retirement savings are equally grim. Let's be honest. Investors probably don't want to listen to anyone telling them to stay the course and stick with the classic asset allocation at this point, after a nearly 60% plunge in the major stock indexes from their October 2007 peaks.
Don't be fooled by last week's stock-market rally. Yes, it was the first time stocks ended higher on four consecutive days since November 2008, but ask yourself: What on the economic horizon has substantially changed since then? Unfortunately, very little.
The use of taxpayer dollars under the Troubled Asset Relief Program (TARP) to recapitalize banks and other financial behemoths isn't working. There has yet to be a consensus in Washington or progress toward removing toxic assets from these institutions' balance sheets to promote lending, and there's a growing sense that the Treasury Dept. isn't any closer to a solution today than it was under former Secretary Henry Paulson a few months ago.
"You listen to [President Barack] Obama and [Treasury Secretary Timothy] Geithner, and people are very confused to know what to do," says William Rutherford, president of Rutherford Investment Management in Portland, Ore. "They don't have a plan that's clear." He believes the clarity needed from top policymakers to lead us out of the woods will only come after another serious drop in stock prices. "I'm expecting it if they don't get their act together. I don't see what they're doing that's going to resolve the problems," he says.
He cites the apparent flip-flop on the "stress tests" the government intended to perform on each of the major banks. Initially, the idea scared people since nobody knew what the stress test would entail or what the outcome would be. "Now we hear the stress test is so easy that just about everybody can pass it. So it's not going to tell us anything," he says. "We'll have wasted another month or more."
Buying on Dips
Rutherford, who says he has long held to a defensive, diversified portfolio, is not doing much that's different from what he had been doing with the $20 million in separately managed accounts he manages. He's done some buying on dips as the market rotates through various sectors and has been able to capture some upside that way. More recently, however, the moves haven't been so much dips as just straight down, which makes it hard to know when to buy a stock, he says. He's sharply reduced his accounts' weight in cash and bonds from between 60% and 70% last fall.
The investment strategists who seem the most grounded these days are those who understand that in the current environment their primary focus needs to be capital preservation. That makes them clear about their role to first preserve their clients' wealth and only then worry about growing it.
Dean Barber, chief investment officer for the Barber Financial Group in Lenexa, Kans., said he began adjusting and safeguarding his clients' portfolios 15 months ago with an eye toward preserving their capital. Most of his firm's clients are already retired.
Federated Prudent Bear Fund
To reduce downside risk in his portfolios, Barber analyzes every mutual fund and exchange-traded fund, searching for the best performers in all the various asset classes. Based on certain expectations, his portfolios use a quantitative model to weed out fund managers with excessive exposures in certain sectors. For example, if he thinks health-care stocks may be in for a rough spot because of the Obama Administration's efforts to reform the industry, "our program will automatically pull managers out of our portfolios who are too heavily invested in health-care," Barber says. "We'll use inverse strategies as they're appropriate," funds that bet on declining prices of particular assets.
Anticipating this crisis, Barber's company in mid-2007 started investing in the Federated Prudent Bear Fund (BEARX), which holds gold and takes short and long positions on individual stocks, as well as investing in hybrid and derivative instruments. Barber says he uses the fund to put the brakes on losses in his portfolios and periodically makes a tactical decision to either add to or trim their weights in the fund based on trends in the market. The fund is up 29.4% since July 6, 2007, and peaked at 57.4% higher from that point on Nov. 21, 2008.
Barber believes that the current financial-system difficulties won't end anytime soon, as banks are still too leveraged and issues with derivatives have yet to be resolved. "We want to stay on the conservative side of things, using short-term government bonds, using some cash, some gold, some inverse positions, and very selectively adding in some equity components."
Defense, Defense, Defense
For Michael Avery, chief investment officer at Waddell & Reed Financial (WDR) in Overland Park, Kans., the game is also all about defense. Fortunately, the Ivy Asset Strategy (WASAX) fund he manages doesn't have style restrictions. By keeping 18% of its assets in gold bullion, 37% in cash, and about 11% in bonds, "we're just trying to survive," he says. He's bought further protection by hedging the fund's 33% equities position with short bets on Standard & Poor's 500 futures, which he rolls over every month. His fund is up 0.7% year-to-date, vs. a nearly 17% drop in the S&P 500 index, he says.
Despite his defensive stance, Avery has become a little more daring lately. While his cash was all in short-term Treasury notes at one point last fall, over the last two months he's moved much of that into top-rated commercial paper to improve his yields and plans to keep it there for the foreseeable future.
Avery's stock allocation tends to be more geared to future opportunities than the present: 40% of it is in Chinese stocks, with an eye toward that country's growing middle class and an imminent shift in the Chinese economy away from reliance on exports to domestic consumption. Two U.S. names he has bought to prepare for China's boom are Monsanto (MON), whose crop protection features will be important as protein consumption rises in China, and PMC-Sierra (PMCS), which makes a chip that will play a role in China's 3G telecom buildout.
It's also critical that financial advisers are prepared to jettison traditional asset allocation assumptions for what could be an extended period of pain. Rich Hughes, co-president of Portfolio Management Consultants, which advises financial advisers who oversee a total of 750,000 individual client portfolios, recommends two rotation strategies that use a quantitative model to assess the risk/reward trade-off between stocks and fixed-income products, combined with the qualitative input of the adviser based on market and political events.
Staying in Fixed Income
In one strategy, advisers choose between fixed income and any or all of the 10 sectors represented in the S&P 500 index, while the second strategy lets them select between fixed income and the stocks in any or all of 20 countries outside the U.S., using exchange-traded funds. "Today, these equity portfolios are 100% in fixed income, because all the signals point to the risk/reward trade-off being more favorable right now in fixed income than in equities," says Hughes. Comprising intermediate bonds, Treasury Inflation-Protected Securities (TIPS), high-yield corporate bonds, and 7-10 year Treasury bonds. the fixed-income portfolio offers a yield of roughly 7.5%. As fundamental and risk-based factors change, he says he expects the portfolios to inch more into stocks.
Hughes views the four-day rally of the week ending Mar. 13 as a technical rebound based on hope rather than changed economic prospects. "It's clearly welcome, but to get overly excited by it is not warranted," he says. "It's going to be a sideways market for the foreseeable future."
But with stocks down by nearly 60% from their October 2007 peak, how can you go wrong buying at such cheap valuations? Even as the major stock indexes were able to log four consecutive days of gains last week, some wary pros warn that this may turn out to be a "suckers rally," when none of the economic fundamentals has changed.
Impervious to Fiscal Stimulus
Of course, there are still some high-quality individual stocks to be had for reasonable prices without putting your portfolio at much risk, says Walter McCormick, a managing director and senior portfolio manager at Evergreen Investments in Boston. Among his favorites are Automatic Data Processing (ADP), since the payroll business will always be needed, McCormick says. In addition, Automatic Data Processing has kept on raising its dividend. Another favorite is Visa (V), which benefits from the expanding use of credit and debit cards worldwide without taking on any of the nonpayment risk borne by retailers and companies such as American Express (AXP).
The real danger, one that most people would prefer not to confront, is that this recession turns out to be one of those rare times in history—such as the early 1930s in the U.S. and Japan in the 1990s—when no amount of fiscal stimulus will work, says Waddell & Reed's Avery.
He cites the analysis by Richard C. Koo, Chief Economist of Nomura Research Institute, the research arm of Nomura Securities, who said that with the asset side of their balance sheets so depleted and little prospect of anything to sufficiently re-inflate it on the horizon, consumers will focus on what they can do: Reduce their liabilities side by paying down debt and cutting back on their purchases.
If Koo is correct, it's going to take a long time for the U.S. economy to recover, says Avery. Investors then will have to navigate the doldrums with some smart defensive strategies.