Amid heightened financial stress in Europe, signs of fading economic momentum outside the US, and mixed US economic data, stocks in the second quarter generally gave up part of their first quarter gains. But that still left “risk asset” returns strong for the first half of the year, paced by real estate (14.9% return for the equity REIT index) and US stocks (9.5% for the S&P 500, 8.5% for the small-cap Russell 2000). Annualized, those returns would be nearly 30% for real estate and approaching 20% for domestic stocks – outsized returns that may not be fully merited by fundamentals.
We continue to hew to a cautious stance, seeking more to manage risk than to maximize return. Our managed portfolios have produced substantial absolute returns, with the trade-off for lowered risk being that they’ve generally not kept pace with strong market averages this year (though they generally outperformed in the second quarter). As financial asset prices have risen, nothing has changed our view that risks at this time are elevated. This list of concerns is not exhaustive, but includes: Europe (financial and sovereign debt crisis), domestic growth (federal debt and deficits, weak manufacturing data, weak labor markets, policy related uncertainty, upcoming elections, looming federal spending cuts and tax increases in 2013, etc.), China (weakening growth there and in other emerging markets), Japan (debt and demographics), significant inflation uncertainty, and geopolitics (especially, Iran and Israel). This list is not new, but the concerns have not dissipated and, in fact, in some cases have worsened.
As the second quarter closed, markets cheered the unexpected outline of a Eurozone bank bailout that emerged from the 19th EU summit since the Euro crisis began (in the spring of 2010). Exceptionally low expectations for a “fix” were well exceeded, but in our view, the new measures constitute still more of “kicking the can down the road” – additional liquidity is fine but doesn’t repair solvency or competitiveness problems, and more debt can’t cure the problem of too much debt in the first place. We still see no easy solutions to Europe, nor can we see any long term outcome that doesn’t ultimately include higher inflation (the timing of which being the really important issue which remains, of course, as elusive as ever).
We do note some significant positives in addition to a sea of risks: chief among them are that valuations are modest, and that both inflation and interest rates remain low. But each of these positive is qualified: stock valuations are modest as long as both unusually high profit margins and unusually low interest rates hold; interest rates will likely remain low as long as inflation remains tame; and inflation will remain low … well, until it doesn’t. And there’s the rub: longer term, inflation looks likely to rise, but in the near term, the inflation outlook is uncertain in the extreme. And that’s perhaps the most important portfolio risk in our long list of risks and unknowns.
Given that, we continue to make each investment decision seeking to protect portfolios against a wide variety of risks (even as different risks require conflicting protections). Compounding that challenge is the fact that what have traditionally been considered “safe havens” – money market funds and government bonds – are especially unappealing now: money funds offer negative yields after inflation and government bond yields to maturity are so low that they’re dwarfed by potential intermediate-term risks. Therefore, we’re left with broad and thoughtful diversification plus careful emphasis on quality as the primary tools we employ. You may be assured that we’re seeking to wrest all the mileage from those tools that can be had.