Assessing the Market in the Context of the Economic Cycle
During the third quarter, the positive performance of the broad equity market was particularly encouraging given the extent of the destruction wrought by Hurricanes Katrina and Rita, the subsequent rise in oil prices from already high levels, and the Fed's uninterrupted pace of tightening. We view the market's resilience in the face of these events as an indicator of the underlying economy's fundamental strength, and we remain quite constructive on the market. In our opinion, we are in the middle phase of an economic expansion, which as history has shown, can last a very long time. Additionally, we are optimistic regarding the market's prospects once the Fed's tightening phase reaches its conclusion: if 1994 is any guide (and we think it is), the markets may be poised for substantial gains, not unlike those experienced in 1995, 1996, and 1997, following the conclusion of 1994's rounds of tightening.
During the onset of this phase, however, investors must contend with what can feel like mixed signals as the market transitions from a robust recovery mode to a more modest—yet potentially prolonged—period of moderate growth. Indeed, already in 2005 we have heard both predictions of stagflation (based on decelerating profit numbers) and of an overheating economy (based on rising commodity prices). We see this back-and-forth as typical of the middle phase, producing a "wall of worry" that the markets can climb.
Although we don't know when the significant upward spikes will occur, our portfolios are positioned for a rising market: with strong corporate profits, increasing capital expenditures, and solid consumer sentiment, we believe the strength and resilience of the economy has the capacity to urge the markets higher in the coming quarters. As noted previously, our in-depth internal research and our macro overview attempts to determine where the economy is headed 12 to 18 months out, and we position our clients' portfolios accordingly. While we have identified the shift to the middle phase of the economic cycle for some time, the market has continued to reward more cyclical, commodity-driven names so far this year, largely due to the run-up in energy prices. Our portfolios have participated in this narrow rally; however, we have avoided piling money into an arena that currently appears to have a great deal of downside relative to its potential upside.
The World is More Normal than It Seems...Mostly
We are positioning our portfolios not for short-term zigs and zags but for long-term trends, seeking to protect assets against broad-based declines. We see the economy operating in a normal range, and where indicators tilt away from the norm, most are positive. Comparing the current economic measures to long-term averages, we arrive at a perspective that is virtually invisible in today's media. Looking at averages over the long term (since 1960), our current situation measures up quite positively: average GDP growth is 3.4%, currently it is 3.3%; average unemployment is 5.9%, currently it is 5.1%; inflation has averaged 4.3%; it is now about 3.5%. These and other measures—including interest rates, earnings growth, and income relative to net worth—all tilt towards positive readings, and all guide our longer-term view on how we should position our portfolios.
A few factors outside of the normal ranges are worth pointing out as well. On the positive side, productivity growth is much higher than historical norms and continues to accelerate as technology and globalization drive secular changes in how business gets done. This is tremendously beneficial and helps consumers since greater productivity is ultimately deflationary, improving the scope and quality of goods and services bought with a consumer's dollar. Second, home ownership levels have now surged well beyond historical norms, reaching all- time highs as a result of low interest rates, tax policies that benefit mortgage debt, and a long historical trend of rising residential real estate prices. We view U.S. consumers as more rational than many give them credit for: they are investing in their homes to enhance their net worth (which statisticians treat as spending), rather than putting money in the bank (which these same statisticians would regard as savings). Were the housing market to slow (probably as a result of rising interest rates), we expect consumers would opt for savings accounts over real estate investments for as long as bank accounts appeared to be the better way to increase net worth.
Other outliers, however, are not so positive, and we continue to monitor them as we factor their effects into our long-term view. One concern we have is the degree to which global growth still depends on the twin engines of the U.S. and China: we'd prefer to see broader-based global growth, which would help offset any hiccups between the two giants. Such growth looks like it is beginning to take hold in Japan, where Prime Minister Koizumi's successful re-election bid was premised on privatizing the sprawling postal system's grip on the nation's savings. Should such growth-oriented reforms continue there, Japan's emergence could take some of the pressure off of the U.S. and China. Currently, although the nature of the U.S./China relationship has resulted in a larger than average trade deficit, we believe it is manageable at this point, but is a concern that we monitor.
The other outlier that worries investors is of course the high cost of oil. We are not convinced that the lack of new U.S. refineries nor the high pace of growth in China are the drivers of the near-term spike in prices: both these factors have been recognized and priced into the oil market for years. Instead, we believe the oil market is being driven by less anticipated situations such as the collapse of hopes for a more capitalistic Russia and the attendant development of its oil fields, the decline of the U.S. dollar (the currency for international oil transactions), and the political situation in the Middle East, where a number of regimes have no interest in seeing the U.S. expand democracy and thus diminish their power. Since oil prices are driven not by a free market but by geopolitical events, we typically do not make large bets in this arena, but we do aim to participate at or near market weights to maintain an appropriate risk/reward balance.
How Our Outlook Shapes Our Strategies
Together, the macro view detailed above helps us to tailor our portfolios, typically in small increments, over time. For example, though we are confident that consumer spending will continue, we are limiting exposure to venues favored by lower-income consumers (such as fast food and discount retailers) as higher energy prices crimp spending habits. Conversely, we believe discretionary spending will remain healthy among wealthier populations, and have therefore put meaningful stakes in areas such as high-end retail, entertainment, and travel-related industries. We recognize that, should the growth of household net worth slow down, there would be a corresponding slow-down in consumer spending, but we believe that the surge in government payouts proposed in the wake of Hurricane Katrina could offset that. Also, robust business capital expenditures will be an additional counterbalance as cash-rich companies continue to spend in their pursuit to remain competitive in the global marketplace.
Equity Positioning
Among equities, we see more attractive risk/reward opportunities among larger-cap, higher-quality names. With low risk premiums in the marketplace, a slowing earnings growth rate and rising prices, we are reducing our portfolios' exposure to cyclical companies and those with highly levered balance sheets. That's because when profit cycles decelerate, the higher-rated, more stable companies far outperform lower-quality names. A recent study has shown that during the last three periods when profit cycles slowed, stocks rated A+ by S&P performed on average more than three times better than the average C and D rated stocks. Also, on a valuation basis, we consider large-cap, growth-oriented stocks to be much more attractively priced relative to their value counterparts, with valuation gaps near historically wide levels.
Throughout the year, we have steadily increased health care exposure, particularly managed health care and health care services. While we have seen a net reduction in our overall technology exposure, we are still mostly equal-to-overweight here, and favor companies that can benefit from wireless infrastructure and communications spending, as well as internet retail/media concerns, which have the capacity to create demand for their own products and services.
Convertible Positioning
Among convertibles, we continue to anticipate the market's recognition of how undervalued the asset class remains. Convertibles have demonstrated the benefits of their hybrid attributes, tracking the equity market in up months and showing their bond-like downside protection during the down periods.
Despite the strong overall performance since May, our valuation models indicate that the asset class remains undervalued, as measured by the relative strength of their underlying equities.
We thus continue to add names that improve our risk/reward profiles of our convertible portfolios and are biased towards higher quality companies. We see more attractive risk/reward opportunities among larger-cap, higher-quality names. With low risk premiums in the marketplace, a slowing earnings growth rate, and rising prices, we are reducing our portfolios' exposure to cyclical companies and those with highly levered balance sheets. That's because when profit cycles decelerate, the higher-rated, more-stable companies far outperform lower-quality names. Also, on a valuation basis, we consider convertibles of large-cap, growth-oriented companies to be much more attractively priced relative to their value counterparts, with valuation gaps of their underlying equities shown to be near historically wide levels.
High Yield Positioning
Among high-yield bonds, we believe the asset class is reasonably valued. Credit spreads, the yield difference between lower quality and higher quality bonds, remain historically tight. This makes sense given where we are in the market cycle, since corporate balance sheets and the economy are in good shape and default rates are low. While absolute yields are below the norm, on a relative basis we believe they also make sense given the low overall interest rate environment. We continue to focus on the higher-quality end of the high-yield spectrum, emphasizing special-situation securities that can benefit from mergers and acquisitions, IPO activity, credit quality upgrades, debt-for-equity swaps, and other positive corporate events typical of a mid-growth expansion.
Also, we have been favoring higher yielding convertibles that may be offering a better relative value than straight high yield debt, as we view the asset class as significantly undervalued.
Conclusion
Despite the current challenges in the marketplace, they are actually part and parcel of the types of challenges that our economy has faced in the past, and are part of the backdrop of a fairly normal to above average economic picture. Indeed our confidence in the economy is steadfast as the U.S. has proven to be resilient when faced with much greater problems in the past. That said, we continue to focus on maintaining the balance of risk and reward in the portfolios, striving to help protect investors from unexpected events that may impact this middle phase of the market cycle. Put simply, in the coming months we will maintain our growth stance and make use of our risk-management tools as part of our core investment approach.