Charting a New Course: Investing in a Volatile Market

2009 began with the worst two-month start in S&P 500 history, but by the end of the year a rally led largely by high-beta, low-quality stocks, helped the S&P 500 recover about half of its total bear market loss.

While this run up was certainly encouraging, the S&P 500 is still over 28% shy of its all-time high and ended the decade with the worst 10-year period on record for the index, producing an average annual loss of 1.0% over that period.

Reservations persist and there is still no official declaration that the recession has ended. However, many indicators signal that the economy has been improving since mid-2009. GDP increased by 2.2% in the third quarter and showed a strong improvement for the fourth quarter, increasing by 5.7% (best since 2003).  Corporate earnings, which have improved faster than expected thanks to aggressive cost-cutting, closed out 2009 with another solid reading. Housing prices have stabilized in recent months, retail sales have rebounded, and consumer sentiment is moving higher. Corporate and consumer balance sheets alike have been improved by cutting spending and paying down debt.

We enter this new decade with the economy in a delicate balance of hope and hesitation. The challenges we will encounter in the coming months are likely to be pivotal in both the direction and magnitude of change to the economy and markets going forward. Some of the more significant challenges of today’s investment climate include but are certainly not limited to:

• Anticipation of future government and central bank policy
• Aftershocks of fiscal and monetary stimulus and the effect on markets, long-term interest rates, inflation, and the value of the U.S. dollar
• Stubbornly high unemployment and its effect on consumer spending (historically comprising about 70% of U.S. GDP)
• Probable higher tax rate environment
• A fatigued housing market subject to a possible rise in mortgage rates (after the Fed ceases its purchasing mortgage-backed securities) as well as the risks of additional foreclosures and “shadow inventory” in the residential and commercial real estate sectors

Looking forward to the new year, our strategic recommendations are necessarily broad in the context of this piece. However, as the year develops we will expand on specific areas of opportunity for investors. At this juncture, however, we propose that it is most prudent for investors to focus on their asset allocation policy, assumptions, and methodology before implementing any tactical asset decisions.

The Importance of Asset Allocation & Liquidity Management

To many, the recent recovery may have seemed like a tidal wave raising nearly all asset classes as it made its way ashore, similar to how it had swept them all away in the previous decline. Investor patience and asset allocation commitments were tested, but for those who stayed the course, a significant amount of their bear market loss should have been recovered.

Seminal studies have indicated that over 90% of investor returns are derived from strategic policy decisions (1986, Brinson, Hood & Beebower). We advise investors that it may be even more imperative at this point in the markets to revisit asset allocation and the specific goals and objectives of the investment policy. However, we also suggest that the process of asset allocation has fundamentally changed from merely charting a course and periodically monitoring the progress, to a more intensive and continuous function whereby long-term targets are thoughtfully compared and contrasted to shorter-term environmental conditions. The assumption that returns will revert to historical trends and follow the concept of a normal distribution over time must constantly be tested against current obstacles and opportunities. Further, while we think asset allocation policy should be within finite bounds to maintain objectivity within the investor’s constraints, it should be fluid enough to accommodate the “economic reality” of the time, placing liquidity at the forefront of the investment process.

Management of liquidity has been extremely challenging in the recent environment and the vast majority of programs have endured less than desirable results. Cash vehicles experienced rapid growth within securitized sub-asset classes (most notably mortgages) and the changing world of liquidity management blindsided cash management professionals and investors. As portfolio managers extended their liquidity pools amongst a variety of spread sectors, cash was—and continues to be—exposed to unintended credit risk.

Investors must step back and re-examine the role of liquidity in their portfolio. Specifically, the timing and magnitude of their liquidity needs, whether their needs are predictable or “on demand,” whether they are focused on capital preservation or income generation, and their general capacity to take risk. Once a framework is developed, liquidity goals and objectives can be met by spreading cash or short-duration investments across successive tiers, thereby reducing risk. Beginning with a tax-exempt money fund, investors can move up the yield spectrum by implementing tiers of short-term municipal bonds, prime money market funds, laddered CDs, or other higher yielding fixed income options. Structuring liquidity into tiers will distinguish the capital-preserving buckets from the yield-enhancing liquidity segments and ensure compliance with the pre-determined framework. Cash is paramount in lending elasticity to a portfolio, enabling rebalancing, facilitating tactical shifts and changing strategic directions without being bound by the cost of transitioning the portfolio.

Portfolio Strategies for 2010

As previously noted, the economic headwinds are numerous. Many investment professionals assert that we are entering a multi-year period with deflated consumption, increased savings and massive de-leveraging. If a recovery is not likely to be led by the consumer or by leverage, where can investors look to enhance returns and reduce risk?

In the new environment, differentiation between the winners, survivors and losers is likely to be more apparent. Those companies with clean balance sheets, free cash flow, and top and bottom line earnings growth should lead their peers, since they should be able to expand earnings organically rather than relying on financing. To execute a strategy based on this premise within the domestic equity arena, investors should retain holdings of well capitalized, high dividend yielding institutions in recession-resistant sectors that still offer relative value. In the international and emerging market equity space, the focus should be placed on countries where debt is coupled with strong reserves. Exposure to these markets can also simultaneously offer some protection against a further decline in the U.S. dollar when utilizing non-hedged strategies. Real estate investments (including REITs) should be approached with caution as the landscape for this asset class is cluttered with obstacles including pending foreclosures, rising interest rates and oversupply. For investors willing to digest additional risk, alternative assets—including hedge funds and commodities—may be able to provide attractive risk-adjusted returns in markets such as this given the right mix of strategy and manager acumen.

For fixed income investors, employing a portfolio of shorter maturity securities can provide some protection from impending interest rate risk and medium- to long-term inflation risk. Bonds at or near investment grade are recommended to avoid the potential default risk associated with some of those institutions that could end up on the wrong side of differentiation. If credit quality suffered further deterioration, high-yield debt would be another sector for which we would urge cautious consideration.

When considering investment in any sector of the market, gradually implementing additional capital by means of a dollar cost averaging timetable is recommended for investors who strive to make the investing process less susceptible to timing risk. By sacrificing potential upside to reduce potential downside in volatile markets, a strict commitment to a dollar cost averaging schedule also removes much of the emotion involved with executing an asset allocation, and frees the investor from hastily altering course at the whim of a market pundit or newspaper headline.