Our investment thesis laid out this time last year was one of caution. We were receiving mixed signals from the market and economies. On one hand equity markets were coming off one of the best years in its history in 2009 and fixed income markets were hitting new highs too. The economy was still on the verge of deflation and very-low GDP growth. The fixed income markets were near all time lows in yield, which suggested many investors were still clinging to the perceived safety of U.S. Treasury Notes. Many investors, including ourselves didn’t fully believe that the actions the Federal Reserve was taking would make much difference considering the scale of the economy and the fact that it is now more than ever a global economy. Worries about the unity of the European Union and fears over a burgeoning debt crisis in Spain, Portugal, and Ireland we abundant in news headlines.
Although we weren’t sure of the direction of the markets for 2010, we knew one thing for sure, that the markets would be volatile. Subsequently we positioned the portfolios to take advantage of this volatility. We favored mutual funds that had the flexibility to exploit short-term volatility in the market. These funds did exactly what we expected them to. They successfully navigated the 10% loss in equities coming into July, with many of our investments still positive for the year at that time. Many of them successfully added to their position in stocks during this time and were able to participate in the very nice rally in stock prices that ensued.
Overall most of our portfolios, depending on risk tolerance, we up around 13.5% for the year delivering an all-equity portfolio type return while taking only a fraction of risk. The key to our success was manager selection. We continuously conduct research to find the best-in-class money managers.
The recovery of the markets have been instrumental in broadening the talent pool. We have seen many new mutual funds started this year, this provides us with more opportunities to look for top-notch talent, which will subsequently benefit client’s portfolios.
Stocks
Equity markets climb the proverbial wall of worry in the fourth quarter with stocks up around 10%. This brought the return for equities up to about 15% for the year. The most sensitive stocks to the economy which include industrials performed the best. High-quality, dividend paying stocks lagged the overall market for both the quarter and year. Investors favored more speculative investments in smaller company stocks. Smaller company stocks were up around 27% for the year handily outpacing the returns from their large-cap brethren.
Fixed Income
The fixed income markets saw increased volatility. Most fixed income, taxable and non-taxable, achieved double digit returns coming into the fourth quarter. However, as the economic picture pointed to a recovery and as worries about municipal balance sheets came to fruition, fixed income securities sold off. Taxable bonds ended 2010 up around 7% even with the 1% loss in the fourth quarter, while tax-free bonds returned about 2% for the year and down about 4% in the fourth quarter. The sell-off in fixed income has pushed yields on many of these bonds back to more attractive levels, but still near all-time lows.
Outlook and Strategy
Our outlook for 2011 remains cautious, as we were last year. We will continue with most of our 2010 strategies for 2011, with the exception of bonds and municipal bonds which may present some difficulty going forward. We have already lowered our allocation to bonds in the third quarter, lowered our bond duration, and are currently lowering these variables even further, especially in the municipal bond area.
About Municipal Bonds
Municipalities’ balance sheets are fraught with debt. States such as Illinois and California are withholding reimbursements to Universities and doctors in order to prioritize their spending. These states are technically out of money and are just prolonging the inevitable reality that they will have make massive spending cuts and increase taxes. In the meantime, municipal bond prices have become more volatile, as investors worry about State and local government defaults and a return of their money at maturity.
We think it is important to protect against the risk that one state or local government will default. We are in the process of moving money out of single-state municipal bond funds in favor of a more broadly diversified and flexible tax-free bond funds. This achieves a few things for us.
- It reduces the probability of a big impact on your portfolio, should a single state default, by increasing diversification.
- A flexible bond fund has the ability to lower the duration of the bond holdings in the fund. This will help us reduce the amount of loss should interest rates increase.
- We are reviewing every individual municipal bond holding in our portfolios making sure that they are the types of bonds we want to hold to maturity and that they have the covenants in their prospectus to make their payments and return our money at maturity
While we believe that the possibility of a nationwide municipal default is possible, the probability is low. The magnitude of such an event is such that it would destroy the creditability of any state or local government and it would be very difficult for them to borrow money again in the future, without having to pay exorbitant interest rates.
So while we may be giving up some after-tax return by employing these strategies in the municipal bond area we believe that a return of you money is more desirable than a return on your money given the state of the municipal markets.
And last but not least, our strategy for municipal bonds is within our overall strategy for fixed income. That overall strategy is to reduce our exposure to the fixed income allocation of our portfolio and add to equity and equity like investments to help improve the overall return of the portfolio. We have identified some new funds we will be using shortly to accomplish this task.
Outlook Summary
Volatility will remain with us in 2011. However, we believe that the portfolios are well positioned to take advantage of this volatility.
Given all of the global economic uncertainty it is all the more important to get the asset allocation right. This is where we have the potential to add value to the portfolios. Flexibility remains a key attribute to managing a portfolio in these uncertain markets. Our skills in creating risk adjusted portfolios and selecting fund managers continues to add value to our portfolios, by giving us equity like returns with lower risk.
To paraphrase Winston Churchill1, “I cannot forecast to you the action of the economy, markets and governments. It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key. That key is our own national interest.”
Yes, it’s difficult to hold back our “can do” American attitude. We are resourceful, creative, and entrepreneurial. We will solve this riddle, wrapped in a mystery, inside an enigma before you know it. We will get our unemployed back to work and our economy on a more normal course sooner than later. We always do.
We just need the political will to get the policies right. The November 2010 election sent a very strong message to the politicians in Washington, D.C. Get it done, or we will replace you with someone who can. We believe they got the message.
As always, we will manage risk first and look for return second. It has worked well for us during difficult economies, and this has been one of the toughest.
