• INSIDE THIS ISSUE
• 
• Opening Article
• Fat Tails From Black Swans
• 
• Featured Article
• MASECO's Strategic Allocation
• 
• Economics
• A Bipolar Recovery
• 
• Equities
• Once More Unto The Breach
• 
• Fixed Income
• Tightening Seatbelts
• 
• Currency
• A Look Back
• 
• Commodities
• All That Glitters
• 
• Special Report
• The Power of Forecasting
• 
• The Numbers
• Market Data
• 
• Contact & Disclaimer
• Contact Information & Disclaimer

Equities: Once More Unto The Breach...

2009 witnessed one of the strongest equity recoveries of all time. Following extensive government stimulus packages in the US and the UK the S&P 500 and FTSE 100 responded to the call to arms and appreciated by 19.67% and 18.66% respectively. In fact returns exceeded 25% in 41 out of 45 countries tracked by the MSCI.

However, taking a longer-term view, the S&P 500 started the last decade at 1,394.46, closing at 1,115.10, with the FTSE 100 opening at 6,268.50 and closing at 5,412.88. Over the last 10 years an investor who bought and held equities would have made little or no money . Stocks have in fact lagged US Treasury bonds by a compounded average of 8.6% per year over the last 10 years. The short-term bounce, whilst creating a warm feeling, really only illustrates how far equities fell in 2008. Since 1926 the S&P has returned an average of 4.3% more per year than Treasury Bonds and, looking at all the rolling 10 year periods since 1926, stocks have outperformed bonds 86% of the time. If one considers the performance of the S&P 500 after a 10 year period of negative returns, the S&P 500 has delivered positive returns over a five and ten year basis. On average the S&P 500 has returned 9%.

As Mark Twain stated: ‘History however doesn’t repeat itself – at best it sometimes rhymes’.

A Bubble Emerging?

Emerging markets did especially well in 2009. The total return for the MSCI Emerging Markets Index (in US dollars) was 79.02% posting its largest ever annual return since the inception of the MSCI index in 1988. Some of this return however was due to general dollar depreciation versus emerging market currencies. The BRICs were big winners last year with Brazil’s stock market appreciating 83%, Russia 113%, India 81% and China 62%. The BRICs outperformed their developed peers, highlighting a continuing shift in investor appreciation for emerging markets as a whole.

When investing in emerging markets, clients have to ask themselves which markets they consider to be categorised as ‘emerging’. Should they leave this decision to the leading index providers, the media or step out and venture into markets as they deem fit on an ad hoc approach? At MASECO we invest in emerging markets using a disciplined approach ensuring that qualitative and quantitative factors are considered before allocating capital to a particular country. Currently a maximum of 12.5% is allocated to a particular country as a risk management tool to control country specific volatility.

Money Flows Tell the Tale

$75bn flowed out of US equity mutual funds in 2009 and into emerging market equity mutual funds. It cannot be ignored that the emerging markets were the main driver behind the world’s equity performance which is unsurprising given their potential for growth and strong relative GDP growth. We have described repeatedly last year how we have been overweight emerging markets from a strategic asset allocation perspective and we still maintain this overweight over the medium term. In large part we believe in this tilt due to favourable demographics, growth prospects, the fiscal situation and the under representation of emerging markets in global equity indices such as the MSCI World index.

Europe also performed well in both absolute and relative terms in 2009 with the DJ Euro Stoxx 50 appreciating 21%. Even emerging Europe with its growing debt problems managed to post impressive returns. The Polish WIG appreciated 47%, the Prague ČEZ appreciated 30% and the Budapest BUX leapt 73%. 2009 was the year that risk aversion abated and many of the riskiest asset classes or markets returned substantial sums.

DFA Returns (Jan 2010).

“No Return to Boom & Bust” (2)

As highlighted in our Q1 Investment Quarterly regarding behavioural finance’s emotional cycle, we can begin to notice that investors in equity markets are no longer fearful of an equity collapse and that some investors may be entering the ‘pleasure’ stage of investor emotions (see chart bottom left). Globally, equity indices all performed well in 2009 and the VIX and VDAX (measures of volatility in equity indices) are both much lower than at the beginning of 2009, confirming risk appetite has returned to equity markets. At MASECO we have no way of timing the tops and bottoms of these emotional cycles and rely on discipline, structure and an adherence to the investment philosophy to invest appropriately across the business cycle.

Death & Taxes

On January 1st 2011 the US tax cuts which were passed near the beginning of the century are due to expire. The US top rate of Income tax rate is due to increase to 39.6%, with the lower marginal tax rates remaining at current levels. Capital gains and dividends are likely to be taxed at 20%. When tax rates were adjusted about a decade ago investors expected a flight to equity participation and also dividend paying stocks. In reality any correlation here is probably coincidental and we would not expect to alter an equity-based strategy based on tax rates. It might be worth considering locking in significantly appreciated gains prior to the tax increase if they cannot be offset against losses in future years.

Rebalancing

The best strategy when investing in a volatile risk asset is to rebalance when the portion of your portfolio in that asset class has either become too large or small when compared to your strategic asset allocation. For equity investors who rebalanced when the markets were very low in Q1 2009, the equity portion of their portfolio may now be much greater than their strategic asset allocation would recommend. In such a case, it would be time to reduce exposure to equities and rebalance back to your strategic asset allocation.