The Quater In Review -- Third Quarter 2009

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By: Jon P. Yankee, MBA, CFP®, AIF®

Are the Markets Back to Normal? So the past seven months have been quite an example of "upside volatility!" While most "experts" did not predict the bear market of 2008 through March 9th of 2009, neither did they predict the enormous rebound that the markets have made since March. Such volatility and unpredictability in the capital markets is what makes the active management of investment portfolios so difficult. At FJY, we continue to strongly believe that the most effective strategy is exposure to all of the world’s markets.

Maintaining diversified exposure to the world’s equity markets paid off for those who invested in the markets during the third quarter. U.S. large cap equities, as measured by the S&P 500 index, climbed for a seventh straight month, and the previous two quarters were the best back-to-back run this index has had in almost 35 years. The seven month rally has pushed the S&P 500 up 56% since its March 9th lows. Moreover, a disciplined strategy incorporating different, non-correlating asset classes also paid off, as emerging markets, international small cap, and commercial real estate were all up more than 20% in the third quarter.

As we continue to explain during our meetings with clients, the markets have historically been “leading” indicators, predicting the direction of the overall economy – and the current strong markets are indicating that the recession may be winding down and signs of recovery are beginning to show. There are, of course, major issues that the U.S. economy must deal with in the future. You can pick up any magazine or newspaper and read about the litany of problems facing the economy, from the budget deficits, to government bailouts, to unemployment. But there are also an increasing number of people who are making the “Case for Optimism.” This case includes the significant impact of the global stimulus, especially in monetary policy; record low inventories that should fuel industrial production and employment; U.S. export growth is up sharply; and housing seems to have bottomed. Does either the pessimistic or optimistic case indicate that the markets are back to “normal?” Or does the fact that there are convincing arguments on each side of the spectrum indicate that the markets have never been “normal?”

Is Modern Portfolio Theory Dead? Earlier this year, for the first time in history, U.S. Treasury bonds had outperformed U.S. stocks over the preceding 10, 20, and 30 year periods...and returns were equal over the previous 40 year period. The equity risk premium that investors are supposed to realize when investing in stocks disappeared over the past 40 years. Of course, if you look over other periods or longer time frames, there is a significant reward for investing in stocks. However, most investors do not have a time horizon that is longer than 40 years. Do these facts mean that Modern Portfolio Theory (MPT), the concept on which FJY’s investment philosophy is based, does not work anymore?

The main concept behind MPT is diversification – the fact that when you select different types of investments, or asset classes, the portfolio of these assets is less risky as a whole than any individual asset. This is because these non-correlating asset classes often behave differently and change in value at different times. Many people believe that 2008 was the death knell of MPT because, they claim, diversification “didn’t work.” But, when you look at years like 2003 and 2004, you can also make this argument...all the asset classes acted the same. But, because the asset classes were all going up – increasing in value – there was not much pain associated with these years by investors and thus, MPT was not cursed as a failed strategy. The major point to remember is that MPT doesn’t guarantee that all of the asset classes will act differently every single year; it is that different asset classes – over long periods of time – will lower the overall volatility (or risk) of your investment portfolio over that time.

The Case for Fixed Income. The interesting part of the MPT argument comes when you introduce behavioral finance, or how people’s emotions affect their decisions, into the equation. The vast majority of the economic/business media and investors’ focus is almost always on stocks, not bonds. Because people tend to find equity investing more fun, or more interesting, or the only thing they are reading about or watching on TV, they usually forget about the importance of “boring” fixed income. So when people and the media talk about MPT not working and how asset allocation did not work in 2008, they tend to forget that fixed income (bonds) should be just as important in that conversation as stocks. High quality fixed income performed like it should have during the downturn in the equity markets, providing a source of stability and cushion against falling equity prices.

At FJY, we take the investing part of financial planning very seriously. We certainly do not discount the perspectives of those who believe that “it is different this time” or that “MPT is dead.” But when one looks at all of the facts, a correct asset allocation to both high quality fixed income and diversified, non-correlating equity assets protects investors over extended periods of time. Not every year...but over extended periods of time. If you have money invested in the bond and stock markets, there WILL be risk associated with those investments. INVESTORS CANNOT RECEIVE MARKET RETURNS WITHOUT ASSUMING RISK. As an investor, you must decide how much risk you wish to assume, and then ensure that your risk is tempered by a healthy dose of high quality fixed income.