This year to date has been good for equity investors (stock and real estate), but less rewarding for investors in the risk reducing asset classes of bonds, cash equivalents, inflation hedges, and market risk hedges. But it's been a frustrating year for rational investors. Dividend paying stocks, for example, have significantly underperformed the market this year even though they have materially outperformed non-dividend payers over the past 40 years. Likewise, high quality stocks have underperformed low quality stocks this year yet they usually do better. As a result of such anomalies and our general caution, portfolios have generally performed quite well this year, but typically not as well as benchmarks.
We expect current Washington, DC brinksmanship will be transient, but looking forward, we remain cautious, mostly because of both the credit bubble and valuations. It’s not entirely obvious, but we are in a Federal Reserve induced credit bubble. After all, consumer credit has not been easy to get and consumer leverage has contracted rather than expanded. But credit has been exceptionally easy to get for governments, and government leverage has experienced an unprecedented expansion over the past five years. Credit bubbles in the late 1990s and again in 2006-2007 ended badly and markets exhibited remarkably short memories when they collectively celebrated the Fed's September surprise decision to continue its massive bond buying program at current rather than slightly reduced levels.
Our concern about equity valuations is complicated. Market prices have generally risen faster than corporate earnings, but that erosion in valuations has not pushed valuations to extremes based on current earnings. However, corporate earnings are elevated largely due to profit margins that are much higher than average, and profit margins tend to be "mean-reverting", that is, periods of unusually high margins tend to be followed by periods of more typical margins (and vice versa). Clearly, profit margins may remain elevated for an extended period, which might allow okay stock returns for the next several years. But a reversion toward more normal profit margins would likely result in considerably lower returns.
We continue to posture portfolios cautiously, with more than bare minimum cash positions, shorter than average bond maturities, emphasis on lower volatility and higher quality equities, and increased diversification by the addition of positions such as reinsurance risk premium funds. If it turns out that market returns are strong over the next few years, our caution will mean giving up some of that upside opportunity. On the other hand, if market returns are poor, portfolios should benefit from this caution and cash will get deployed at considerably better valuations than currently offered. That's a trade-off we're willing to take in this environment.