Searching for True North
September 24, 2009
Well-intentioned people can disagree over the Great Recession's place in history. In one important sense, though, the chaos of the past 18 months has been unprecedented. It has shattered deeply held beliefs about the basic functioning of the stock and bond markets and left the best minds in finance—to say nothing of ordinary people—grasping for explanations.
The sacred texts of investing need to be rewritten. It turns out that the so-called equity risk premium, the once-sacrosanct belief that stocks perform better than bonds over time, has been vastly overrated. Earlier this year, according to the Leuthold Group, a Minneapolis research firm, U.S. Treasury bonds had outperformed U.S. stocks over the preceding 10- and 20-year periods. And that was only the beginning. Bonds also beat stocks over the past 30 years. Even the 40-year returns were basically equal, a feat never before witnessed in the U.S. markets. Over other periods, of course, stocks performed far better. But for four decades they were a sucker's bet.
If the bedrock principle of investing—that shareholders are compensated over the long term for the risk of buying equities—is a fallacy, then what, if anything, can investors believe in? Which assumptions can be trusted? What is "normal"? During the panic the markets were "way out of whack," says John H. Cochrane, a finance professor at the University of Chicago's Booth School of Business and vice-president of the American Finance Assn. "I don't know what's going to happen to the stock market next. And I have a highly educated view that no one today really knows."
Amid this cosmic confusion, two opposing theories are emerging. One group of prognosticators claims the markets are in the throes of a "new normal," a long period of slow growth during which old investing rules will give way to new ones. The other group says the epic abnormality of the past few years will soon be swept away by a massive reversion to historical patterns. Depending on whom you believe, today's stock market is either a trap door or a coiled spring.
Caught in the middle are thousands of professional investors searching for the market's true north. They don't have much time to fumble around: Their livelihoods depend on people believing that they know what they're doing. Managers of mutual and hedge funds are struggling to figure out not only how to make their customers money but also how to justify their fees. Financial advisers are rethinking outdated formulas of "asset allocation" as clients demand more safety. Pension fund managers face the politically dicey task of rebuilding their portfolios without taking on excessive risk or demanding bigger contributions. All are yearning for signals of how the future will play out.
STARVED FOR CAPITALThe executives at Pacific Investment Management, or PIMCO, say they have the answer. The bond fund giant has adopted the phrase "new normal" to describe the changes taking place. "If you are a child of the bull market, it's time to grow up and become a chastened adult," writes William H. Gross, manager of PIMCO Total Return (PTTRX), the world's largest bond fund, in his September dispatch to investors. "It's time to recognize that things have changed and that they will continue to change for the next—yes, the next 10 years and maybe even the next 20."
PIMCO cautions stock investors to accept lower returns long into the future. In the new normal, says PIMCO, economic growth will continue to be slow and unemployment high as the U.S. loses clout to China and the rest of the emerging economies.
PIMCO CEO Mohamed A. El-Erian, a 15-year veteran of the International Monetary Fund who later managed Harvard University's endowment, contends that the economic crisis will run so deep that it will vanquish all assumptions about stock market valuations. As the economy's growth rate resets lower, he says, a broad swath of companies will find themselves starved for capital. The easiest, and increasingly only, way for them to recapitalize will be to issue more equity, "diluting" or even wiping out shareholders' assets. "That reality," El-Erian says, "is not captured in the equity risk premium model and what people assumed was normal. Stock prices will come to reflect this threat permanently."
PIMCO is in the belly of the recession beast. Its Newport Beach (Calif.) headquarters are in Orange County, aka Subprime U.S.A., home to cookie-cutter subdivisions populated and then vacated during the real estate boom and bust. The county famously went bankrupt in 1994 but collected itself enough to chase ruin anew a decade later. An eerie quiet pervades the place. Along the freeway, defunct mortgage startups have shrouded or dismantled their billboards.
Whatever just happened in the markets has been unmistakably good for PIMCO. The firm has taken in $120 billion of fresh assets since the start of 2008. Since its 1971 founding, PIMCO has increased its assets from $12 million to $842 billion, $180 billion of which is concentrated in PIMCO Total Return. That portfolio has returned an average of 6.34% over the past five years, well north of its 5.14% benchmark and the 2.25% loss posted by the Standard & Poor's 500-stock index.
El-Erian, who is also PIMCO's co-chief investment officer, is highly skeptical of the stock market's recent rally. "Interest rates are at zero, there's $2 trillion plus on the Federal Reserve's balance sheet, and yet the economy is still losing jobs," he says. "What exactly is the stock market romancing?" According to PIMCO's new normal, equities should make up just 30% to 54% of a portfolio, with no more than half in the U.S.—much less than the traditional 60% commitment to stocks and 40% to bonds. Of course, PIMCO, a bond shop, has an incentive to paint stocks as less attractive. But other asset managers are sounding a similar theme. One is Robert Arnott, chairman and founder of Research Affiliates, a research and analytics firm also based in Newport Beach whose strategies guide $43 billion in institutional investments. "Most investors hold portfolios that rely too much on a sizable equity risk premium," he says. "With 50% or 60% invested in stocks, equity declines can overwhelm bond returns."
Arnott's research, published in a March note to clients, finds that the standard 60/40 stock/bond mix had almost a one-to-one correlation with the S&P 500. In other words, the Treasury bonds in that hypothetical portfolio would provide no diversification. The new normal of asset allocation, Arnott posits, calls for radical diversification into inflation-protected Treasuries, commodities, and other assets less correlated with stocks.
OLD NORMALISTSAt the other end of the philosophical spectrum are what one might call the "old normalists"—people who believe the stage is set for a dramatic return to traditional patterns. "The new normal," says Kent Engelke, chief economic strategist at Capitol Securities Management in Richmond, Va., "is really just the old normal reverting back to the [long-term] mean."
Between 1900 and 1999, old normalists point out, stocks gained 12.9% a year, vs. 4.7% a year for bonds—no small spread. "Market history says returns for stocks and bonds will reverse to a normal state, where risk is appropriately rewarded with higher returns," says Eric C. Bjorgen, senior analyst at Leuthold Group. So striking is the apparent disconnect that Leuthold in June sent clients a 35-page report titled "Exploiting Generational Anomalies in Stock vs. Bond Returns."
Investors are having trouble making sense of the debate over normalcy. Far away from Newport Beach, in the steel country of Wexford, Pa., lives Ronald H. Muhlenkamp, a veteran fund manager and founder of Muhlenkamp & Co. "I don't know what the new normal is," says Muhlenkamp. "Everybody wants to find something in the past that looked like this. I don't see anything. I can only monitor the present."
Muhlenkamp, 65, has just suffered three of his worst years since launching the fund in 1988. In 2008's growler of a bear market, he posted a 40% loss. Despite a 32% gain thus far in 2009, Muhlenkamp lags the S&P 500's three-year annualized loss of 4.5% by three points. "For money managers," he says, "what worked in the past 40 years did not work in the past two."
Muhlenkamp is in that nether region between studying the past and getting stuck in it. Normalcy, he argues, is in the eye of the beholder. "My granddad was lame because a rooster pecked him in the knee," Muhlenkamp says. "That was his normal. He'd never dream he could have three-minute arthroscopic surgery today."
Muhlenkamp isn't alone in his consternation. All manner of so-called active managers are reeling from their worst year on record and trying to prove their worth in an era of low-cost index funds. Even sophisticated hedge funds, which were designed to hedge, or protect, against 2008-style catastrophes, fell 18% on average last year. The drubbing was not only an embarrassment for high-fee funds promising "absolute returns" but also shocking in that the results were just two points better than the loss posted by a plain-vanilla 60/40 stock/bond allocation using inexpensive index funds.
Given the market's violent swings of late, the task before active managers will likely get harder before it gets easier. Has investing ever been more confusing than in 2009? First the Dow Jones industrial average lurched toward 6500, a level that, adjusted for inflation, hadn't been seen since 1966. Next it surged 52% even as unemployment headed toward double digits. "We've never had a six-month period where we've lost 2 million jobs and the market has gained 50%," says Barry L. Ritholz, noted economics blogger and CEO of FusionIQ, a quantitative research firm. "That's simply unprecedented."
Muhlenkamp is working hard to rebuild his asset base, which despite a 40% rise in 2009 has plummeted from $3 billion in 2006 to around $900 million today. Last September, amid Wall Street's meltdown, Muhlenkamp went 30% into cash, his highest allocation in 10 years, and in January he bought bonds for the first time since 1983. He did, in other words, everything the textbooks suggested would avert disaster—to no avail. "It wasn't enough to save us," he says. "I let a lot of people down." In March, he says, one 20-year client called to sell out, only to phone again in August to get back in, after having missed out on a 50% gain.
The notion of "normal" is especially vexing for financial advisers and planners, the professional asset allocators who help structure portfolios for retail investors. For them, decisions about how to spread money around have never been more difficult—at a time when customers have never been so skittish. Some advisers, fed up with the old models, are charting a new course. Jerry Goss has run money for clients out of Baton Rouge, La., for 29 years, 27 of them for A.G. Edwards, the Midwestern brokerage whose roots date to 1887. Wachovia acquired A.G. Edwards in 2007, one year before Wells Fargo (WFC) swooped in to take over Wachovia during the financial panic. Says Goss, 60: "2008 was the second-worst year of my life." (In 1992, Goss was diagnosed with non-Hodgkins lymphoma and endured nine months of chemotherapy.) "It's one thing to have clients call you about their portfolio losses. It's another to have to defend your bank as it blows up."
Goss for decades put his clients' money in mutual funds, including some run by American Funds and First Eagle, buying-and-holding his way to double-digit annual returns. That success ground to a halt this decade, culminating in an average 30% drop in stock holdings last year. "I did a lot of soul-searching," says Goss. "The market we have today is vastly different from anything I've seen in my career."
Goss resents how the mutual funds in which he put customers' money failed to act as the markets tanked. Instead of being tactical and moving aggressively out of stocks and into cash, he says, his funds stuck to antiquated models of asset allocation, failing to appreciate the damage a 30% equity loss can do to a small investor's portfolio. (After suffering a 30% loss, an investor would need to gain 43% to break even.)
As the market plunged to its March low, Goss reinvented his investment approach. Now buy-and-hold is out, and "tactical asset management"—moving money to the sidelines when conditions warrant—is in. Goss liquidated his clients' mutual fund holdings in March and kept as much as 40% of the proceeds in cash. He then plowed that cash into commodities and international exchange-traded funds, the two sectors that have flashed brightest in relative strength since March, according to Richmond-based research house Dorsey Wright & Associates. Yet for all his toil, Goss has trailed the S&P by a hair since he launched the strategy in March. While outperforming the benchmark would be nice, he says, it's "no longer as important as protecting on the downside. It's now all about not losing money."
MISSING A STOCK RALLYManagers of elite public pension funds are just as confused as private money managers about how to invest, and they have an added dimension of ugliness to deal with: politics. According to Boston College's Center for Retirement Research, state and local pension plans, many of which have assumed 8% annualized returns, are running at least $1.2 trillion short of their target. To be fully funded, they'll have to see contributions rise sharply—no easy sell to taxpayers in this era of gaping deficits. Pension funds got into this mess in part because they've adhered to outdated investing approaches. The Great Moderation, a theory that rose to prominence in the late 1990s, held that economic cycles would be longer and milder than in the past and that investors could therefore feel comfortable investing in higher-yielding but illiquid, or difficult-to-sell, assets. Amid the panic of 2008 the values of some of those assets crashed, devastating many a pension fund portfolio. Worse, because illiquid assets can't be unloaded quickly, funds have had less flexibility to dive back into the rallying stock market. As a result, some of the largest, savviest, and most influential pension funds in the world are lagging common stock market benchmarks—and are beginning to draw the ire of state and local politicians.
In Florida, the State Board of Administration, which oversees $110 billion in pension assets, had a 12.5% gain in the second quarter, short of the S&P 500's 15.2% rise. Why the underperformance? The fund had reduced its stock holdings to invest in illiquid assets, thereby missing the chance to capitalize fully on the recent once-in-a-lifetime stock market rally. "Certain asset classes and subclasses lagged," acknowledges SBA executive director Ashbel C. "Ash" Williams.
The California Public Employees' Retirement System (CalPERS), the nation's largest pension fund, is in a political dogfight. Its asset value in 2008 plunged a record 23.4%, worse than the performance of a basic 60/40 stock/bond portfolio. The $56.2 billion loss wiped out six years of earnings for CalPERS' 1.6 million working and retired clients, according to Bloomberg. "We're still negotiating what's happening in the markets," says a CalPERS spokesman. "Like everyone else, we don't have a crystal ball."
Far from it. According to internal documents reviewed by BusinessWeek, CalPERS in 1999 was assuming it would generate annual returns of 8.25% over the following decade. Since then the fund has posted an average annual gain of just 3.25% and has lowered its return assumption to 7.75%.
In July, CalPERS reckoned that it could close its funding gap over the next 15 years if it were to post annual returns of more than 8% and if state contributions were to grow by more than 4%. Given the fund's recent track record, those results seem highly optimistic. Amid the sharpest stock market rally in decades, CalPERS has cut its stock holdings from 56% to 49% and plans to devote much of its proceeds to illiquid investments.
Taxpayers, naturally, won't be keen on contributing more. Governor Arnold Schwarzenegger has already demanded reduced benefits for new hires. "CalPERS has for a long time been assuming fantastical investment returns it could never reach," says David Crane, special adviser to the governor for jobs and economic growth. "In turn, the state made pension promises it couldn't keep." The backlash has been so strong that one municipality, Pacific Grove, near Monterey, is looking into ditching CalPERS altogether and replacing it with a 401(k)-style system.
But would a private 401(k) really be better for Pacific Grove's employees than mighty CalPERS? Sure, as long as those investors figure out how to fine-tune their portfolios perfectly for the new normal. Or the old normal. Or whatever. Good luck with that.