Investment Highlights

 Summary

Eurozone government leaders have proclaimed that they're committed to keeping their single currency intact. A €440 billion European Financial Stability Facility (EFSF) has been in place for some time to assist high-debt nations. More recently, they’ve reached agreements on how best to expand the EFSF, on the “voluntary” level of losses accepted by owners of Greek sovereign debt, and the proper level of European bank capital. But beyond the headlines, the focus should rightfully be on fiscal reform and the prospects for growth. On that score, a solution remains elusive. While the political agreements are likely to prevent another ‘Lehman event,’ Europe may not be able to avoid recession.

 Selected Highlights

• There has been acknowledgement that Greece’s debt-to-GDP ratio will surpass earlier forecasts and, absent restructuring, could exceed 180%, as the Greek economy is likely to be much weaker than previously believed. Thus, the structural reforms being put into place will likely take longer to gain traction and debt will continue to accumulate.
   
• Shares of European stocks in general (and banks in particular) have been poor investments recently. For example, Credit Agricole, one of France’s largest financial institutions, has declined some 40% since June 30. While some may attribute this to fears of exposure to sovereign debt that may be subjected to a ‘haircut,’ there’s also the prospect that near-term credit demand may be weak. This would crimp bank earnings and stock valuation.

• October’s Purchasing Manager’s Indices (PMI) were not encouraging (see chart below). The PMI indices can, at times, portray the near-term direction of sectors of the economy. These series – one dedicated to Services and the other devoted to Manufacturing – suggest that Eurozone GDP is set to contract. This only reinforces our cautious view of the region. 
  
  

 

The opinions in this newsletter are for general information only and are not intended to give specific recommendations or advice.  Certain information contained herein has been compiled from independent, third-party sources believed to be reliable.  Hamilton Capital Management makes no representation about the accuracy, completeness or timeliness of the information contained herein or its appropriateness from any given situation.

Against this background, corporate profits have exploded. Profits have never been higher and are now well above pre-recession levels. In contrast, stock prices have not kept pace. We believe the S&P 500 is now trading at its most fundamentally attractive level since the U.S. economic recovery began – creating opportunity for the disciplined investor.
Accordingly, our equity portfolios continue to place significant emphasis on U.S. large-company stocks. We believe this asset class has the most attractive total return prospects over the next 12-24 months relative to other equity classes, cash equivalents and most types of bonds. 
Unlike bear markets, corrections tend to be short-lived. This one may linger a little longer, but we don’t think it will lead to market declines of the severity and length experienced from 2007-2009.   In fact, if it takes the same course as other past corrections, recent declines should give way to a strong price rally that eventually carries the market to new highs.
Further action towards resolving the European debt crisis and gaining more clarity about the current U.S. economic slowdown likely will be necessary to end this correction. Here are our thoughts on those matters:
European Debt Crisis: There finally seems to be progress here. Previous plans to resolve this crisis centered on Greece avoiding default by implementing austerity measures that reduced their deficits. The hope was that if budgets were trimmed, then economic growth would shrink Greece’s sovereign debt as a percentage of its GDP, making it more manageable. But its economy slowed and interest rates on its debt exploded, making this plan unrealistic. This realization has led to recent financial market turmoil.
We’ve remained confident that a more workable plan will be found. It appears such a plan is now taking shape. While the focus remains on Greece meeting planned austerity measures, it now appears a restructuring of Greek sovereign debt is being considered as a way to end the crisis. And since many European banks are significant holders of this debt, any restructuring plan must address the impact on these banks’ financial reserves. A further consideration is the need for the plan to contain the crisis at Greece’s border by shoring up similar but less acute debt issues in other European countries. All of these details are currently being weighed.
Until a plan takes final form, we expect financial markets will continue to be volatile, experiencing both strong up and down movements. However, we continue to believe that the various leaders of the Euro-zone, including its largest economy (Germany), know that it’s in their best interest to come to a joint solution. Failure to address the issue in a timely manner has the potential to cause far greater damage to their banking system and export-driven economy than the burden any solution may impose.
Possible U.S. Recession: Wall Street has a saying: “The stock market has forecast 10 of the last 2 recessions.” In other words, numerous market corrections have occurred in anticipation of U.S. recessions that never materialized. And while the risks of the U.S. slipping back into recession have increased, this may be one of those times when the markets are forecasting a recession that doesn’t actually occur.
While the economy has slowed, giving rise to recessionary concerns, U.S. economic releases continue to paint a picture of an economy in a soft patch – meaning less rapid growth, not recession.   Further, leading indicators (economic releases that provide a glimpse forward) paint a similar picture. Therefore, while a slowing economy can stall and fall into recession, we feel the most likely economic scenario continues to be for anemic growth, but growth nonetheless.
Our Equity Portfolios: The media seems to have mainly focused on how the slowly growing U.S. economy has not made a dent in the high unemployment rate. Widely underreported has been the explosion of corporate profits, which have been anything but anemic. In fact, as measured by National Income Accounts (a broad measure released with GDP), profits have never been higher and are now well above pre-recession levels reached in the fourth quarter of 2006. 
And while record earnings are good news for equity investors, current equity prices are perhaps even better news. The advance in stock prices has not kept pace with the increase in earnings. In fact, with the recent correction, the S&P 500 is now trading at its most fundamentally attractive level since the U.S. economic recovery began. We estimate that prices are now more than 30% below their intrinsic values, creating opportunity for the patient investor.
Our investment process commits portfolio resources only to those asset classes that represent attractive opportunities for total return over the next 12-24 months. With this in mind, we continue to position our equity portfolios to place significant emphasis on U.S. large-company stocks. While their prices may move lower as the correction runs its course, we believe this asset class has the most attractive total return prospects over the next 12-24 months relative to other equity classes, cash equivalents and most types of bonds. 
Looking Forward: As part of our process, we continually research and analyze the global investment environment. We go to great lengths seeking to understand what comes next so that we can proactively take advantage of opportunities and avoid unnecessary risk. Right now our equity portfolios are intentionally invested to take advantage of the opportunity in U.S. large-company stocks. Rest assured we will make any necessary adjustments as new opportunities and risks emerge.

• Chart 1 shows a comparison of the Thomson Reuters/University of Michigan index of consumer sentiment (grey) and the price of the Standard & Poor’s 500 (S&P 500) equity index (scarlet). As noted with the light blue and green ovals, this measure of consumer sentiment seems to peak roughly when the market peaks and bottom about when the market troughs. So, if an investor is only fully invested when sentiment is highest, then they own the market when prices are most expensive. Conversely, if investors are getting out of the market when sentiment is bottoming, they have tended to sell when stock prices are cheapest, historically.

• An analysis by DALBAR¹ tracked the behavior of individual investors, which is heavily influenced by sentiment. It found that their emotion-driven decisions led to consistent and significant under-performance of benchmarks, often in response to bad news.

•  We tend to focus on fundamentals, such as earnings. Chart 2 (the S&P 500 index versus corporate profits as measured by the National Income Accounts) suggests that the recent sell-off in U.S. stocks, while difficult to experience, wasn’t based on the current success of company profits. Quite the contrary. With profits moving to a new record high, and prices recently moving lower, we seem to be far from anything near Buffet’s “cheery consensus” in the market. In other words, the market is negative, yet profits are at record levels. This has traditionally been good for future returns.   

Summary

 

After a recent update of our forecasts for future earnings streams, we’ve decided to reduce our exposure to Small Cap stocks, which we feel are expensive relative to traditional Small Cap fundamentals (e.g., earnings and P/E multiples).  In exchange, we’re further increasing our investment in larger companies. In doing so we’re introducing an alternative investment, an “Equal-Weight” S&P 500 index fund, to our portfolios. We expect that, over time, this core holding will provide incremental return over the benchmarks while providing our clients with valuable diversification to company, sector/industry and sub-advisor exposure at a lower cost.

 

Highlights

 

Ø  We have maintained a modest “underweight” position with Small Cap stocks for some time, meaning those positions have been smaller than the weights we view as “neutral” for each strategy. We’ve favored Mid Cap stocks and Large Cap stocks instead due to their fundamentals. A neutral position is the weight we hold if all asset classes have comparable return outlooks.

 

Ø  In this portfolio shift, we’re moving the Small Cap position even more underweight -- down from its neutral position. After an extensive review of causal fundamental factors, we feel that even with generous allowances for earnings growth and future P/E multiples, this group of stocks is relatively expensive and likely to under-perform. Therefore we’re increasing our position in the Large Cap universe.

 

Ø  Since we already have large positions in a number of Large Cap managers, we’re taking this opportunity to employ an Alternative vehicle that we have studied for some time – an Equal-Weight S&P 500 index.

 

Ø  This is a passive investment vehicle. Although it shares the “index fund” nomenclature with traditional index funds, it weights each stock in the S&P 500 equally. This differs from traditional passive funds, which weight each stock by its market capitalization weight.

 

Ø  These funds charge lower fees than bottom-up security selectors and can offer superior company and sector/industry diversification. They have a track record of strong performance, including in risk-adjusted terms. Some research also indicates they perform well during challenging market periods, which we believe can offer risk mitigation in what we expect will be a moderate, uncertain recovery thanks to the global, private-sector deleveraging process.

 

Ø  In the Equal-Weight S&P 500 index, each stock will have approximately a 0.2% weight. For comparison, in the traditional S&P 500 index fund, the largest stock, Exxon, has a 3.45% weight as of 3/31. Traditional index funds tend to favor companies that have already succeeded, and could generate lower future returns. Although there is a place for traditional index funds in portfolios, we believe a diversified and carefully constructed portfolio can generate better risk-adjusted results.

 

Summary

 

We are in the midst of updating our review of the dollar, and specifically its potential impact on inflation, interest rates, credit spreads, earnings and equity prices.

Our research implies that a lower U.S. dollar alone doesn’t necessarily lead to higher inflation.  This doesn’t mean there won’t be inflation over the coming months.  It simply suggests that other factors often play a role in the inflation rate. 

 

Highlights

Ø  The chart below shows a comparison of U.S. inflation using headline consumer prices (left-hand scale, year-over-year percentage change) and the U.S. dollar’s value calculated against a basket of foreign currencies that are weighted based on the amount of trade with the U.S.  For easier analysis we inverted the U.S. dollar line, as a rising dollar tends to reduce inflation and vice versa.  Therefore, a declining dollar is reflected in a rising dollar line (in red).

 

Ø  As you can see, both measures can be volatile over short periods of time, so we analyzed the relationship over longer periods.

 

Ø  In three periods, the notion of a declining dollar leading to rising inflation (or vice versa) appeared to hold valid (periods 1, 2, and 6). However, in four other periods (3, 4, 5, and 7) the assumption that a declining dollar leads to inflation doesn’t hold true.  

 

Ø  In fact, in period 3 the dollar experienced one of its steepest declines (inverted line, so decline = upward sloping red line) yet the rate of inflation actually declined. Further, between 1981 and today, the U.S. dollar has declined modestly despite the fact that inflation has collapsed.

 

Ø  Therefore, although the dollar is one factor impacting the direction of domestic inflation, other factors – interest rates in the U.S. vs. other countries and vs. inflation, our trade balance, and government fiscal balances among them – can overwhelm the direction of inflation.

The opinions in this newsletter are for general information only and are not intended to give specific recommendations or advice.  Certain information contained herein has been compiled from independent third party sources believed to be reliable.  Hamilton Capital Management makes no representation about the accuracy, completeness or timeliness of the information contained herein or its appropriateness from any given situation.