100% in Equities?
In February 2012 one of the very few Wall Street executives whose stature actually increased during the financial crisis, Blackrock CEO Larry Fink, told Bloomberg why he liked stocks:
“I have been pretty consistent on this since last August. I would be 100% in equities. I think Chairman Bernanke is telling you I am going to keep bonds down so low you can’t make a return that’s going to meet your needs owning bonds. It is not that bonds are bad. Bonds are priced so high that the return on bonds is just so minimal. I don’t have a view the world is going to fall apart. You need to take on more risk, you have to overcome all this noise, and there are great values in equities. Equities are at a 20 or 30 year low in valuation. When you look at dividend returns on equities versus bond yields, to me it is a pretty easy decision to be heavily in equities.”
Scared Stockless
We agree with Larry and would add that, in addition to attractive valuations, stocks’ fundamentals have rarely been better. Companies are efficient, shareholder friendly, and uncommonly disciplined in their use of capital. Nevertheless we expect the Stock Avoidance Syndrome to continue. Investors have been so traumatized by recent bear markets, ongoing turmoil in Washington, and Federal Reserve over-reach that they are not going to quickly rotate from bonds into stocks. Over the past three years investors pulled $291 billion out of equity funds and invested $476 billion in bond funds. In the past two years there were only five months with positive flows into stock funds and two months with negative flows out of bond funds.
This is not a case of Main Street ignoring the sage advice of Wall Street. Unlike Mr. Fink, Street strategists are still sufficiently risk averse that they are willing to accept the “minimal” returns available in the bond market. Goldman Sachs is telling clients of its private bank to have 54.5% of their money in bonds, just 25% in stocks, and 20.5% in a range of “alternative investments” including hedge funds, private equity, and real estate. Another major wealth management company is similarly cautious on stocks, recommending that wealthy individuals put 44% in stocks, 37% in bonds, 17% in alternative investments, and 2% in cash.
Alternative Alternatives
Aside from risk aversion, a second reason why investors are not following Larry Fink toward “100% equities” is that the alternative is not just bonds; they can also buy a panoply of “alternative” investments such as hedge funds and private equity. Portfolio managers can strive for equity-like returns without touching publicly traded stocks. Consider the endowments of Princeton, Harvard, and Yale, which tend to be “thought leaders” in the non-profit world (see tables). They agree with Larry that bonds are overpriced and have on average just 5.9% of assets in fixed income. But their allocation to stocks is also pretty limited, averaging just 21.6%: 16.3% for Princeton (including 7.3% in domestic equity), 33% for Harvard (11% domestic), and 15.7% for Yale (6.7% domestic). Even though these folks hate bonds, only 8% of their assets are in domestic equity. Their big bet is on alternative assets, which claim 72% of total assets, on average.
Individual investors are following the Ivy League money into these “alternative investments,” but will they really deliver attractive returns as money pours in? We’re skeptical. According to Merrill Lynch, hedge fund assets have climbed from $539 billion in 2001 to $2 trillion in 2011. Most of it is in market-neutral strategies (long / short equity, macro, risk arb, etc.) to capture market inefficiencies, but the flood of money chasing these strategies will reduce returns. Wall Street research is increasingly focused on short-term events; unlike in the 1990s, there are fewer lumbering “long-only” funds for hedge funds to trade against. Reg FD (requiring broad disclosure of material information) leveled the playing field in the stock market, and it turns out that illegal inside information was a significant source of hedge fund outperformance. Hedge funds offer investors an unappealing combination of high fees and low liquidity. In bear markets a la 2008 withdrawals by panicked investors may force funds to sell stocks at the bottom.
Given all these problems, it is not surprising that recent hedge fund returns have been poor. The Financial Times’ Gillian Tett quotes a hedge fund expert who advuses J.P. Morgan: “the vast majority of all hedge funds worldwide have well underperformed virtually every major stock or bond index for some four years.” Their performance versus stocks looks pretty good during equity bear markets, but – believe it or not – stocks do tend to rise over time; after 12 years of poor performance stocks may well outperform the over-crowded hedge fund space.
As for private equity, its prospective performance is harder to figure because it is, well, private. But, like hedge funds, this arena is far more crowded than a few years ago. One indication: no less than 27 individuals on the Forbes 400 list made their billions in private equity. In the future the copious capital committed to private equity may exceed the available attractive investments, depressing returns.
The Stock Avoidance Syndrome Is Far from Over
For these two reasons, S.A.C. will be with us for a while. This could dampen stock market returns but is far from bearish. After all, stock prices have already climbed 75% since March 2009, and stocks soared in the 1980s (up 218% between 1982 and 1989) even though individuals avoided stocks because of high volatility (think program trading and the 1987 crash) and – in contrast to now – high returns from money funds and bonds. What SAS does mean is that the stock market will be less frothy than in the late 1990s, when lots of dumb money crowded into equities.
Individual Investors Should Exploit Their Unfair Advantage
We often hear that the market is “rigged” against individual investors. This may be true for traders, but the opposite is true for patient individual investors who can build a diversified, tax-efficient, long-term portfolio of high quality stocks with growing dividends and then hang onto them through an economic cycle, selling only those stocks whose fundamentals really deteriorate. (For example, individuals didn’t need to sell their industrial and material names when China’s economy slowed in 2012.) Individuals who follow that strategy should not only do better than bond investors, but also better than supposedly sophisticated investors in hedge funds and private equity—particularly after taxes and fees.
Individuals actually have an unfair advantage over professionals, who are compelled to play the short-term performance derby by trading in and out of stocks based on their Wall Street popularity. That’s a loser’s game; for example, no one could have predicted AAPL’s 57% rise, 17% decline, 32% rise, and 27% decline over the course of 2012. Playing the risk on / risk off game is similarly futile. Professional traders are constantly looking for story stocks with a short-term “catalyst” while overlooking boring high-quality companies whose earnings will grow over time.
Harvard Endowment Policy Portfolio
Yale Endowment Asset Allocation
Princeton Endowment Asset Allocation
Copyright Thomas Doerflinger 2012 All Rights Reserved
