By TREVOR CALLAN, Callan Capital
Thursday, September 2, 2010
Just as investors were feeling good about the stabilizing economy and financial markets, the second quarter of 2010 reminded us that we live in a world full of risk. The BP oil spill combined with worries about a double dip recession, the European debt crisis and the uncertainty in Washington relating to fiscal austerity, health care, financial and tax reform have all increased the level of worry and volatility. Watching the evening news is enough to make the most seasoned investors question the structure of their portfolios.
The good news is that time, in general, diffuses volatility. According to a recent study in JPMorgan?s (NYSE: JPM) ?Guide to the Markets,? from 1965-2009 a portfolio consisting half of stocks and half of bonds never experienced a decline over any five-year rolling period. That said, it is possible and even prudent to rebalance your portfolio from time to time in a measured fashion to take advantage of ever-changing market dynamics.
Caution on bonds
For example, in today?s market, bonds are trading at historically high levels and are vulnerable to price reductions. Historically, investors could rely on insurance and ratings agencies to provide comfort about the underlying safety of their bond portfolio. Today, many investors are holding municipal bonds purchased when insurance companies were still considered solvent. Those investors would be wise to have a financial adviser examine the underlying quality of their existing bond portfolio and not rely on the rating agencies alone.
Fear and uncertainty has caused investors to flock to safety, driving bond prices higher. Bonds are currently trading at levels that warrant caution in our opinion, because bonds that have long maturities are more susceptible to rising interest rates.
Fear and uncertainty have also kept stock prices from rising, and, given the trends in recent earnings, equities provide value for investors with a longer-term time horizon.
Higher equity earnings
Equity markets (stocks) continue to fluctuate under the influence of economic news, political uncertainty and fiscal austerity. But as the second-quarter earnings season progressed, it appears that the underlying fundamentals warrant higher prices, but fear over the direction of the economy has caused stocks to drift lower. Only a few months ago, the consensus earnings estimate for the 500 largest U.S. companies was $17.17 per share. Those 500 companies actually earned $19.41 per share, much higher than anticipated. Currently, the consensus estimate for the second quarter is $19.61, and so far the majority of companies have exceeded their estimates. Most people contribute the recent earnings growth exclusively to cost cutting (earnings grew 29 percent year over year), but U.S. companies have also experienced healthy revenue gains (8.7 percent year over year).
The risks of a double-dip recession have increased lately, but we still feel that the most likely scenario for the U.S. economy is for a continued slow, painful and uneven recovery. Our equity portfolios have a slight emphasis on the cyclical parts of the economy and the sectors that derive a large percentage of their revenue from overseas sources. Currently, our international equity portfolio is focused on countries experiencing economic growth combined with prudent fiscal policies such as some the Asian and Emerging Markets (with the exception of Japan).
Prior to 2008, investors considered themselves diversified by owning a portfolio of just stocks and bonds. After 2008, we experienced an increase in correlation across a number of asset classes that historically provided diversification. So, investors may also consider alternative investments for diversification purposes. Examples including strategies that can go long or short, private real estate, distressed debt and consumer receivables. Adding Treasury Inflation Protection Securities (TIPS), commodities, precious metals and agriculture as an inflation hedge can also help balance a portfolio.
Our financial system is efficient over time and has a unique ability to flush out excesses that are occasionally created by irrational exuberance. This cleansing process, which is painful in the short term, is what sets the stage for continued and healthy growth in the financial markets and investment portfolios over the long term. Investment portfolio diversification is key and protects against unforeseeable risk, but prudent and consistent adjustments to capitalize on shifting market dynamics can maximize the performance of an investment portfolio.
With the increase in recent volatility, investors should question their temptation to exit asset classes that are meant to provide an inflation hedge over a longer-term time horizon. A 65-year-old today has a 16.1 percent chance to live to 95 and a 5.1 percent change to live past 100, according to the Centers for Disease Control and Prevention. Most people should be constructing their portfolios to meet the income needs over an appropriate time horizon.