Letter from the Portfolio Manager Archive

Key Points:
• Chasing performance is the biggest mistake many investors make.
• One asset class that investors have piled into this year is fixed income. While we believe the fixed income asset class demands a strategic role in all investor portfolios, investors should have modest total return expectations moving forward.
• While we recognize that gold is a popular investment with many investors these days, we instead prefer a basket of commodities over a single commodity; and we prefer natural resource stocks over commodities.

Route 128 is the beltway that surrounds the Boston area. While it serves the function of avoiding downtown Boston, it is no easy drive for those who have to commute on it each day. It's a wearing, steady “stop and go” and sometimes those “stops and goes” are quite abrupt as drivers attempt to shave any possible minute off their commutes.

Every major city has highways like Boston's Route 128. And every city has drivers that constantly switch lanes as they move from a slower to a faster lane. Even though the lanes on the left tend to have the fastest flow on average, and the lanes on the right tend to have the slowest due to merging and exiting traffic, drivers often try to outsmart their fellow commuters. And yet, the new lane will often quickly become the slowest (while at the same time introducing risk to all on the road from those frequent lane switches). How many times have you seen that? In the end, there is no greater return for making the switch. If anything, time is usually lost and the frustration of a long drive increases.

This scenario is similar to what many long-term investors do with their investment portfolios. They tend to switch to what they see as the fast moving lanes of the financial markets and away from what they perceive are the slow moving lanes. The problem, however, is they are often moving into what was fast by selecting investments after they have already risen considerably in price. And, the investments they are moving away from tend to be those that have already fallen in price but are now on sale. In other words, investors are chasing performance by buying high and selling low.

Chasing performance is easily the biggest mistake investors make. Various studies capture this. One notable study that monitors investor behavior on an annual basis is from DALBAR. In short, DALBAR monitors flows in and out of mutual funds to capture the actual investor experience and then compares that performance to stock and bond indexes over various time frames. The results aren't attractive. Over the twenty years ending December 2008, the popular stock market benchmark S&P 500 index averaged a gain of 8.4% a year. The average equity mutual fund investor, however, gained only 1.9% a year over that time frame. The average investor also underperformed over the prior three and five years.

For fixed income investors, the results were similar as the Barclays Capital U.S. Aggregate Bond Index gained 7.4% a year for the past twenty years through the end of last year while the average fixed-income mutual fund investor gained only 0.8% a year. Bond investors also underperformed the bond index over the prior three and five years.

As money manager Ron Muhlenkamp likes to say, the investor who buys into the hottest performing segments of the market is similar to planting corn in October since it had grown so well since April.

So, where are investors planting corn these days? There are two areas I would like to briefly discuss.

Fixed Income
As of the end of October, mutual fund investors had sold more equity mutual funds than they bought in 2009, especially domestic equity mutual funds. Despite frequent statements in the press about “excessive investor optimism,” it is clearly not reflected in mutual fund flows. Investors are still leaving the stock market. Where is that money going? The bulk of those flows are going into fixed income mutual funds.

While we continue to believe that fixed income, either through individual securities or though mutual funds, serves a valuable role in providing income as well as diversifying a portfolio by reducing over-all portfolio volatility, investors should not have high expectations for the long-term total return potential of investment grade fixed income.

The U.S. ten-year Treasury, for instance, closed the month of November with a yield of 3.2%. Assuming the bonds are held to maturity, the return will be just that -- 3.2%. And that's the nominal return. That does not take into account inflation. Currently, the market expectation for inflation over the next ten years (as measured by the yield differential between ten-year nominal Treasuries and ten-year TIPs) is 2.1%. If that expectation comes to pass, the after-inflation return will be just over 1% (for comparison, the long-term average real return for the stock market is closer to 7%). If inflation is worse than 2% though, which would be plausible given the long-term average is over 3%, then the real return could even be negative.

Yet, many long-term investors are favoring bonds over stocks. The biggest reason is that the pain of the recent bear market is still relatively fresh in people's minds. To bolster their case, many investors say they prefer bonds because they provide better long-term returns. When one looks at recent ten-year returns, as measured by the S&P 500, that is true. The ten year return for the U.S. stock market is negative.

On the subject of ten year returns for the stock market, however, I would like to quote well-known portfolio manager Bill Miller from his third quarter shareholder letter when he talked about all ten-year rolling returns since 1871:

“…There have been 14 10-year periods where stock returns have been negative, including this one. In every one of the previous 13, the subsequent 10-year returns have exceeded 10% real, about 50% more than average, and more than double the return of government bonds. So every time stocks have performed poorly for 10 years, they have performed better than average for the next 10 years, and they have beaten bonds every time by an average of 2 to 1, yet investors can't put money fast enough into bond funds, and continue to redeem equity funds.”

Gold
I get a lot of questions on gold these days. And for good reason as "Buy Gold" is heard everywhere, from dinner parties to ads on sports talk radio. Just replace "gold" with "tech stocks" or "residential real estate" or "ethanol" (and the list goes on and on) as the lead character, and this is a story we have all heard before -- and we know how the story ends.

What factors drive gold? Among the many, the big two right now are concerns about rising inflation and a weaker dollar. Both concerns are related to the federal deficit. While as a citizen, taxpayer, and parent I am also concerned about the federal deficit, I do not share the heightened level of concern as many others do -- at present. Could we see rising inflation and a weaker dollar soon? Sure, we could. That said, the probabilities of both are overrated in my opinion.

As for rising inflation, our economy is in the process of deleveraging and unwinding some of the total debt (mostly consumer) that has been accumulated in years past. This process is inherently disinflationary. Also, though it's likely that the employment situation will begin to improve soon, there is currently no wage pressure (the lead factor for inflation). Additionally, there is massive excess capacity in the economy. Real inflation is not likely to take hold until some of this slack is absorbed.

It is interesting to note that while inflation expectations may be well articulated in the press, they are not in the market. The absolute levels of longer-term interest rates (the size of the U.S. Treasury market is vastly larger than the gold market) and market-based inflation expectations both suggest that inflation will remain below-average in the foreseeable future. While we will likely see an up tick in inflation later this year (as year-over-year numbers are compared to the late '08 free-fall in the price indices), I believe that given the aforementioned factors inflation is not likely to significantly rise.

Another factor that could prop up gold is a weaker U.S. dollar. If there is one thing that rivals the love that many people have for buying gold, it is hating the dollar. Recent price action does tend to confirm dollar weakness as the dollar has slipped substantially in recent months (though the dollar is still above the lows from the summer of 2008). The main reason for the recent weakness, however, is that investors are becoming less scared of the markets (though they are surely not bullish yet) and they are reversing the panic trade from late last year and early this year. It's important to remember that the global economy still sees the U.S. dollar as the "gold standard" for currencies. When times got tough during the panic, global investors wanted the U.S. dollar. Besides, the dollar is fundamentally cheap right now. By our in-house calculation, the dollar is nearly 10% undervalued versus a basket of currencies and over 20% undervalued versus the euro.

Since we manage portfolios to maximize total returns for a given level of risk, our preference is to own basket of commodities instead of a single commodity. A basket of commodities is a cleaner way to benefit from global growth, especially from the emerging economies (without having to pay high valuations that EM securities often possess). Besides, if gold does benefit from a weaker dollar and higher inflation, then surely a basket of commodities will too. And, when it comes to commodities, we currently prefer natural resource stocks as the natural resource companies have operating leverage and could additionally benefit from higher stock market prices.

Dow 40,000
Ten years ago, a book called “Dow 40,000: Strategies for Profiting from the Greatest Bull Market in History” was published. In many respects, this book along with many others published around that time were among the foundation documents for many investors to go heavy on stock market exposure – and just in time for one of the worst ten year stretches in U.S. stock market history.

Now, the business books that dominate the best-seller lists and the airport bookshelves have a whole different theme and tone – and investors are responding by going heavy on non-equity exposure.

The Dow Jones Industrial closed November above 10,300. The S&P 500 closed just under 1,100. Assuming price appreciation of 7% a year (which in my view is not exceptionally heroic given that long-term nominal corporate earnings growth is 6% a year coupled with the view that the stock market is still slightly undervalued), the Dow Jones could be at 40,000 and the S&P 500 at 4,000 in approximately twenty years. Given current life expectancies (the typical 60-year old in America, male or female, is currently expected to live at least twenty more years), avoiding the stock market doesn't seem reasonable. We believe that staying the course with the appropriate level of stock market exposure remains a prudent way to achieve long-term financial objectives.

If you prefer, the Letter from the Portfolio Managers is also available in a printable PDF format. The PDF will open in a new window. You will need Adobe Reader to view this document - click here to Download Adobe Reader.

The investment ideas and expressions of opinion may contain certain forward looking statements and should not be viewed as recommendations, personal investment advice or considered an offer to buy or sell specific securities.

Kobren Insight Management's statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. You may request a free copy of the firm's Form ADV Part II, which describes, among other things, affiliations, services offered and fees charged. Past performance is not an indication of future returns.