Compass October 2013

In this issue:

Compass is the quarterly newsletter of Creekside Partners. All information is obtained from sources deemed to be reliable, but is not guaranteed as to accuracy. Nothing in this newsletter should be construed as financial or investment advice to any reader. All material herein is the copyright of Creekside Partners.

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Investing or Speculating? And…the Regret Syndrome

As summer moves to fall and as events in Washington move from comic to absurd to tragic, we contemplate the state of the markets. As devoted value investors, we turn first to the fundamentals. What are the earnings on stocks, and will those earnings grow faster than the rate of inflation over time? Is the price the market has set for a dollar of those earnings in line with our long-term investment expectations? What is the interest rate on bonds, and will that rate properly compensate us for inflation over time?

Only then can a value investor make a reasoned opinion. Financial assets (stocks, bonds, CDs, etc.) are not real assets themselves. They are contracts that give you a claim on a real asset. When you buy a share of General Electric, you have a claim to roughly one ten-billionth of GE’s earnings. GE’s earnings are the real asset; you merely own a piece of paper that says you have a limited right to a teeny piece of those earnings.

When buying a bond, you own a contract that gives you a claim to a portion of the bond issuer’s revenues or assets. Example: If it’s a California general obligation municipal bond, you have a claim on a specified portion of property tax revenues.

In each of these cases, the stock or bond is not the real asset. The real assets are the earnings and property taxes. You buy stocks to invest in earnings. You buy bonds to invest in cash flow. You buy real estate investment trusts to invest in rent. Prices of those stocks, bonds and REITs should, in normal times, move in reaction to investors’ forecasts of those real income streams.

At present, the stock and bond markets are not trading on the basis of valuing these underlying real assets. Prices are rising and falling in reaction to perceived political actions. In other words, investors are not placing bets on future corporate earnings, they are placing bets on the outcome of budget negotiations in Washington. To put a more subtle point on it…investors are placing bets on what they think other investors will do in reaction to the daily political news cycle.
In this type of market, fundamentals don’t matter. The market has turned from its primary role of valuing future income streams, to making speculative gambles on obscure committee negotiations.

One might argue that future earnings will depend on those budget decisions. And we are here to tell you…no, they won’t. The federal budget moves like a battleship…slowly, with most of its direction over multiple years already built into its current momentum. Further, over half of the earnings of the S&P500 companies are realized from overseas customers that don’t give a hoot about the US budget.

Times like these can temp the value investor like the Sirens on the rocks. If your bets on short-term political outcomes are right, and if you get the timing right, you can make good money. When the Fed unexpectedly announced no reduction in its bond-buying program, bond prices rose sharply. If you made that bet, you made fast money. A week ago, rumors came from Washington that a budget compromise was near at hand. If you made that bet the day before, you made fast money the next day.
The current environment is a classic example of the difference between speculating and investing. When you invest, you acquire the right to receive future cash flows. Your analysis is pretty much limited to what you want to pay for those cash flows. You are not concerned with whether or not someone else agrees with you, or what someone else might pay for those same cash flows two months hence. When buying bonds, you are not concerned with what a 10-year bond might be worth in a year. You are mainly concerned with whether or not the yield will keep you ahead of inflation, and whether or not you’ll get the principal back in 10 years.

The current theme underlying short-term stock market activity is political in nature. But it’s merely the “flavor of the day.” As any market gets into peak, over-priced territory, trading becomes disconnected from fundamentals. Deep down, investors know the gig is up and that the music soon will stop. They’re not looking so much for signals to buy, but rather signals to find a chair quicker than the next fool. Buying tends to be driven only by recent selling. That is, an investor might move to get out of stocks, only to find out that he was early. So then he buys back in. Volatility ensues.

We are watching the foolishness in Washington like any fed-up citizen. But we are not letting it affect our investment decisions, because it doesn’t. All of this turmoil is just a wave passing along in a river. It comes, it goes. The river still gets to the same place. On the following page, we talk about where we think the river is headed, and what we are doing about it.

The Regret Syndrome

We’ve never met a friend or client that did not desire a balanced portfolio. Meaning: One that has some stocks, some bonds, some foreign, some domestic, etc. Different asset classes have good years and bad years and a properly diversified portfolio will be more stable over time. And then, along comes a year like 2013. Despite starting the year at already high valuations, the S&P500 has soared another 19%. And we all wish we had owned more stocks.

Yet a balanced portfolio holding a mix of 50% globally diversified stocks and 50% diversified bonds has returned just 6% or even less in 2013. The “safe” asset class (bonds) has returned about zero for the year; the “risky” asset classes (stocks, etc.) have returned 10% to 20%. And this is exactly the point at which many investors allow their regret over not owning more stocks affect their decisions. Investors are now tempted to move more and more money into stocks.

A balanced portfolio is the correct strategy, everywhere and at all times. There will be years when the balanced approach is the clear winner; there will be years when it is not. But over time — particularly over the long “retirement horizon” timeframe — the balanced portfolio always wins out.

Stock Valuations

Longtime readers of our periodic commentary will recognize the name Robert Shiller. Shiller is a professor at Yale who has done groundbreaking work on the workings of markets, particularly stocks and housing. We were happy to see that Professor Shiller’s work was recognized with his award this month of the Sveriges Riksbank Prize In Economic Sciences in Memory of Alfred Nobel (commonly called a “Nobel Prize,” although it is technically not).

Shiller has published compelling work on stock market valuation. In particular, what measure of stock market valuation is most predictive of future returns? Rather than ask, “What has been the average return on stocks?” Shiller was wise enough to ask, “What has been the average return on stocks, if they were purchased at various valuations?”

Shiller argued (as do we) that the appropriate measure of Earnings in the “Price/Earnings” ratio is not last year’s earnings, nor a forecast of next year’s. It is to use a sensible smoothing of earnings over a 10-year period, and adjusted for inflation (Shiller called this “normalized earnings”). By that measure (often called the “Shiller P/E”), the S&P500 is selling at 24 times normalized earnings. We want to answer this question:

What has been the annualized return to stocks over the next five years at various Shiller P/E ratios?

And so, we have plotted below the data since 1901. Each blue dot represents a 5-year holding period. The axis along the bottom shows the annualized return on stocks for each dot. The red number on the vertical axis shows the Shiller P/E at the beginning of that 5-year period. We have drawn an arbitrary vertical black line to split returns into two halves: Whether we earned more than 5% (dots to the right), or less than 5% (dots to the left). We consider 5% the bare minimum we need to earn from stocks in order to make them worth the risk. We can buy bonds that pay that much, without taking risk.


We have drawn a red horizontal line that shows today’s market valuation. The result is four “quadrants,” the right two of which are good (High Returns) and the left two of which are bad (Low Returns). At present, we are living in the top two quadrants — the two with High Valuations. We want to end up in the top right.

What should be readily apparent is utter scarcity of dots in the upper right quadrant. Buying stocks in a High Valuation market has almost always led to disappointment. The overwhelming majority of the High Return dots occurred following periods of Low Valuation — the lower right quadrant.

Conversely, the vast majority of the blue dots lying above the red line are skewed sharply to the left. Adjusted for inflation, most of them are negative. As mentioned in the main article to the left, this is not a time to increase allocations to stocks.

Bonds Are Dead. Long Live Bonds.

We have confused more than one person with our continued devotion to municipal bonds as an asset class. Folks hear that and respond, “Bonds? Everybody is fleeing from bonds. Don’t you read the newspapers? Bonds don’t pay anything and rates are going to go up. Bonds are dead.”

We respond by pointing out the high yields and tax advantage of muni bonds. And we are summarily waived off.

But we finally get it. Yes! We agree that the bond market is overvalued and doesn’t offer enough yield to make it worth owning the asset class. Did we just contradict ourselves?

No…we simply recognize the fact that there is not one single bond market or type of bonds. When commentators and pundits talk about “The Bond Market,” they mean the market for government bonds and very high-grade corporate bonds. [As an aside, they used to also mean FNMA bonds, but those days ended in 2008.]

When talking about that particular corner of The Bond Market, we absolutely agree. We would no more buy a 10-year US treasury than throw money out the car window. High grade corporate bonds will barely keep up with inflation after taxes. With rates more likely than not to rise over the next few years, bonds will be available with higher yields if we are patient. We have almost no client money invested in medium- and long-term high grade bonds. We agree! The 30-year bond market rally has finally ground to a halt.

But wait…what is this over here…? Municipal bonds. An entirely different market.

Municipal bond yields remain disconnected from “The Bond Market.” In normal times, munis yield less than taxable bonds of similar quality and maturity. That’s because the interest earned on munis is tax-free. A California resident is paying as much as 48% in combined state and federal taxes. A 3% muni bond is the equivalent of earning 5% or more on any other asset. As shown in the chart from the previous page, the average return on stocks in the five years following market conditions like we see today is just 2.5%.

If a treasury bond pays 4%, most investors end up with about 2.6% after taxes. So if a muni bond can be acquired at 3%, you come out ahead. A 3% muni in a 4% world is normal.

But today, muni bonds can be acquired at yields that are higher than yields in The Bond Market. With 10-year treasuries yielding about 2.7%, 10-year muni bonds of the highest credit quality are trading at over 3.0%. In other words, muni bonds are paying yields that they would pay if 10-year treasuries were over 4.0%.
If interest rates in The Bond Market do, in fact, rise to 4%, we will be happy to keep owning our muni bonds at 3% since the after-tax return on 4% bonds is around 2.6% (or less) for most of our clients.

Yield is one reason to buy certain types of bonds right now. The other is preservation of capital. When the stock market has a “historic selloff,” it is usually in the 25-40% range. This past summer, bonds had the “worst selloff in history,” and fell barely 5%. They have since recovered most of that decline. Bonds preserve capital.

As (we hope) we made clear on the previous three pages, we are not eager to deploy more money into the stock market. Yet we are not willing to sit in cash (earning nothing) or buy long-term high-grade bonds (falling behind inflation). We are willing to buy muni (and a few select taxable) bonds in the 5 to 7-year range. These bonds give us the certainty of knowing our funds will be safe, and a very high probability of staying ahead of inflation in the short term.
We don’t like bonds. We love bonds. It depends on what kind of bonds.