Dear Fellow Investors:
A tremendous amount of energy and effort has been expended in the US on behalf of wealthy investors to secure returns while reducing risk. Like any useful endeavor, it started out as a wise thing and reached its stride in the late 1990’s as a way to deal with a massive asset misallocation. As Warren Buffett always says, “What the wise man does at the beginning, the fool does at the end”. It appears to us that the efforts to eliminate risk in the US capital markets have reach the “foolish” point.
We at Smead Capital Management believe this because everyone learns in their first economics class that competition from new suppliers causes marginal profits to move to zero. We observe almost all the wealth managers in the marketplace practicing risk reduction strategies in wide-asset allocation models. Therefore, we have three questions to answer for you today. What happened in the last 30 years to lay the groundwork for today’s circumstance? Why has the profit disappeared for those who seek to reduce risk? Is this an unusually favorable time to take risk in the US?
I came into the investment business in 1980. Decades of inflation and miserable returns from bond investments had driven interest rates to sky-high levels (20% prime/15% Ten-year Treasuries). A pair of crippling recessions in 1980-82 broke the back of inflation. The bond market took until 1993 to fully adapt to a more moderate inflationary environment and “wise” investors feasted on double-digit returns in their interest-bearing instruments. When the money market funds hit 3% and long-term Treasury bonds dropped near 5% in 1993, investors had to move elsewhere to seek double-digit returns. As bond and interest bearing securities matured between 1993 and 1999, wealth advisors helped investors pursue high returns in US equities. This phenomenon was based in large-cap growth stocks and was led by the technology sector. By 1999, individual and institutional investors had left the bond market for dead.
The concentration and misallocation of capital in the largest US large-cap stocks was legendary. The S&P 500 index peaked with around 37% of its capitalization in tech and telecom stocks in early 2000. The Federal Reserve Board’s Z-1 1999 year-end report showed that common stock ownership dwarfed household ownership of bonds and other interest bearing instruments like CDs and money market funds. Almost every other asset class was starved for capital as investors sought to be pioneers by investing in ways to make money from “the internet changing our lives”.
Twelve years have passed, including two 40%-plus bear market declines in US large-cap stock indexes. The first one decimated tech investors and the second one decimated everyone else, precipitating a mass scramble to reduce risk. Ironically, those who anticipated these circumstances enjoyed outsized returns in the asset classes (emerging market equity and debt, gold, oil and other commodities, junk bonds, etc.) which were starved for capital in 1999. In other words, diversifying them into reduced risk and raised returns. We’ve called this asset allocation “Nirvana”.
As wealth managers around the country witnessed asset allocation models spitting out above-average returns by being widely diversified, they quickly moved in to get their share of these high profit margins. We estimate that by the summer of 2011 such a large crowd of wealth advisors and institutional investors had populated the wide asset allocation space that marginal profits were approaching zero. Too many animals were feeding at the same trough or grazing from the same fields. It appears that the same thing is happening in the alternative investment space, where hedge fund results found only 13% of managers beating the S&P 500 Index in the first nine months of 2012.
In a very effective video interview at Morningstar.com, Christine Benz interviewed Bill Bernstein, a widely followed asset allocation expert. He argued that wealth managers have “overgrazed” in wide asset allocation. Here is how he stated things recently:
Bernstein: Yes. So, that’s the first aspect of it, the return aspect, the overgrazing. The first person to the party gets filet mignon, the last person to the party gets a hamburger or worse. And unfortunately everybody is trying to be little David Swensen right now, and not everybody can be David Swensen.
But there is second aspect of it, as well, which is the correlation aspect. The first people to the party, the first people to invest in a new asset class or the first people to invest in a recently disgraced asset class that’s had a catastrophe–it doesn’t have to be a new asset class, it can be an old one that’s gotten hammered–the first people tend to be very disciplined. They tend to have very strong hands. They will hold on during the market decline. But when everybody and their dog owns the asset class, when the average exposure to alternatives, for example, in an university endowment is well over 50%, a lot those people are going to be weak hands. They’re going to be people who will sell at the first sign of trouble. And when that happens, the correlation goes way up, and the classic example of that recently, of course, was commodities funds. The correlation now with commodities funds with the stock market since the crisis is in the range of 0.7 or 0.8; it used to be much lower. And that appears to be a permanent condition, that appears to be a permanent shift.
At our firm, it appears that overgrazing has occurred in every asset class which has received massive inflows motivated by economic and stock market fear in the US or by the erroneous belief in China’s uninterrupted growth. Take a look at what are the most popular writers of weekly and monthly macroeconomic and US stock market timing advice and you see a list of extremely bright pessimists. These pessimists are contributing to the “overgrazing” of popular asset classes and have scared most of the animals away from taking risk in the one asset class which offers under-grazed territory. Using commodities as a favorite of the pessimists, here is what Bernstein said in an answer to one of Christine’s questions:
Bernstein: Well, that’s an interesting issue. Commodities were first noticed as a diversifying asset class back in the early ’90s when the data first became available from the Goldman Sachs Index. And the problem was that before 1990, you couldn’t really get exposure to them and unless you are the very biggest of players like David Swensen. What you have to do is literally jump into the pits and deal with these futures; you couldn’t actually buy a fund, or a simple vehicle that did it. You had to find at best a manager that could do it for you. And those were very thin on the ground. You didn’t (know) who they are, and very few people knew about this asset class.
The more people who found out about it, the more the alpha got overgrazed. And with commodities there is a very easy way of measuring how overcrowded it is, which is what’s something called the roll return which is the difference between the futures index and the spot index. And that became negative sometime around 10 or 11 or 12 years ago, and it has been persistently negative ever since as the PIMCOs and the Oppenheimers and the Goldman Sachs and the Yales of the world have all piled into it.
Therefore, in our opinion, commodities as an asset class (along with blackjack, sports betting, the craps table, etc.) are a severely negative sum game.
Which asset class is under-grazed because of a severe reluctance on the part of wealth advisors and their clients? Lipper has reported that large-cap US stock mutual funds have suffered 41 consecutive months of liquidation, despite clobbering the returns of most of the other asset classes! Wealth advisors have been convinced by the brilliant pessimists to keep very low commitments to US stocks. The NACUBO study shows that dollar-weighted US equity holdings among endowments and foundations dropped from 36.7% of overall portfolios in 2002 to 15% by the end of 2010. They are likely lower now, if Lipper’s information and anecdotal evidence is valid.
Why do we believe you should be optimistic about US large cap equities at the present time? 1) Valuations are below historical averages, especially compared to interest rates and inflation. 2) Dismal economic prognostications are everywhere and any surprise to the positive is not discounted. 3) The US has 85 million echo-boomers averaging around 28 years of age. Aging will drive them to marry, have kids and buy houses and houses have never been this affordable in my lifetime. 4) China’s economy is slowing even before they admit that unpaid loans from 2008-2011 could cripple their financial system. We believe commodities have entered a 5-7 year bear market and that the stimulating affects of lower oil and other commodity prices will be huge. 5) The dearth of optimists makes the risk-reward relationship incredibly positive and under-grazed.
As portfolio managers of a US large cap stock portfolio, this means we must be incredibly careful with the energy, basic materials and heavy industrial sectors of the S&P 500 index. They have suckled on China’s uninterrupted growth and the commodity boom. Second, we believe we are receiving bargains among what we call “staple” consumer discretionary companies with addicted customer bases. Third, we like the money which we think we can make from dealing with baby boomers living long lives with chronic illnesses treatable with pharmaceutical products. Lastly, we like the US financial institutions which will benefit from any positive surprises about our economic future.
In summary, while everyone is looking to reduce risk and is accepting little or no return in the process, we argue that seeking out well-chosen risk in the under-grazed US large-cap stock market is the thing to do. After all, isn’t that what introductory economics classes have taught us?
Best Wishes,
William Smead
The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
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