Fourth Quarter 2011 Letter to Clients

If we learned anything in 2011, it’s that the “experts” know just as much about the short-term direction of the market as individual investors.

Which is to say: Nothing.

The year was notable not only for debt crises and stock volatility, but also because some of the most high-profile gurus in the investment industry made spectacularly wrong calls about where the “smart” money should be in 2011.

Two of the analysts/managers who made their fame by predicting the collapse of the real estate bubble in 2008 led the “guru to goat” pack in 2011. Banking analyst Meredith Whitney, who became a certified guru by predicting the 2008 financial crisis, sent municipal bond investors into a tizzy heading into 2011 with this dire prediction on “60 minutes” in December 2010:

"There's not a doubt in my mind that you will see a spate of municipal bond defaults. … You could see 50 ... to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars' worth of defaults."

In fact, though, there were just a handful of municipal defaults in 2011, and only two sizeable ones: Harrisburg, Pa., and Jefferson County, Ala. In all, defaults came in at less than $10 billion – far below Ms. Whitney’s prediction of “hundreds of billions of dollars” in losses. Moreover, the municipal bond category was the best performing segment in fixed income, gaining nearly 10% for the year.

Ms. Whitney’s counterpart, hedge fund guru John Paulson, made his fame by booking multi-billion dollar gains betting against the mortgage-backed securities market prior to the 2008 real estate collapse. Yet this past November, Mr. Paulson felt compelled to issue an apology to his shareholders for the dramatic losses his funds had incurred – including one which had plunged 44% through October – due to his ill-timed bets on financial stocks, including Bank of America and Citigroup.

Meanwhile, the world’s most celebrated bond-fund manager, Bill Gross, saw an ill-timed bet against U.S. Treasury Bonds backfire on his Pimco Total Return bond fund. Treasury bonds returned nearly 10% in 2011, compared with just a 4.2% gain for Pimco Total Return – a return that placed the world’s largest mutual fund in the 70th percentile of its peer group. For what it’s worth, Mr. Gross has now done a complete reversal and is advocating for Treasuries in 2012.

So what may we conclude from the missteps these celebrated investment experts experienced in 2011? Did the “smart” suddenly become “unsmart”? Did their crystal balls crack?

In our view, it is none of the above. The bad results these high-profile managers and analysts produced are simply a reflection of the reality that no one knows what the market will do in the short term, and those who believe they do – and make decisions as if they do – will, at some point, learn that they don’t.

This “guru to goat” pattern is well-established in the investment industry, going back many decades. It stems from the craving investors have to find a sage who knows what the future holds. In present tense, it is hard to identify these sages because there are so many “experts” making so many different calls. So we look back at the historical record and find those who seemed to make the right calls. Given the sheer volume of talking heads who are making predictions about the financial future, it is, of course, inevitable that some small number are going to be right. Those who are right about the most pressing issues are quickly identified by the media and dubbed “the analyst/manager who predicted (insert issue here).”

Fame and fortune quickly ensue, as the media and investing public hang on their every word. In due course, however, the reality of having been the lucky dart-throwing monkey catches up with the gurus, and investors who followed their advice are left with a lot less money than they had before their guru turned to goat.

* * * * *

No sooner did U.S. large cap stocks emerge from their worst decade in history than the inevitable call to “just buy blue chips” – last heard in the mid-1990s – re-emerged as well.

Indeed, 2011 was a good year for large cap stocks relative to other equity asset classes. The Dow Jones Industrial Average logged a 5% gain for the year, while the Russell 2000 index of small stocks lost 5%.

And during the stock selloff in August and September, large cap stocks held up better than small cap stocks, causing many pundits to question the value of diversification. Thus we get the sudden focus in the media on the merits of “the Nifty 50,” “Dogs of the Dow,” and various other large cap stock strategies that come flying back around like a well-thrown boomerang any time large stocks return to the top of the heap.

The reality is that, in any panic-driven market downturn like the ones we saw in October 2008 and again this past August/September, asset-class returns are going to align very much with risk. Riskier asset classes will decline more – temporarily – than less risky asset classes. Thus we see stocks fall more than bonds, small stocks fall more than large stocks, foreign stocks fall more than domestic stocks, etc. But this is a short-term scenario. Once the panic selling abates, we also typically see a rapid recovery in the riskier assets, as we saw in 2009-10 and again this past October.

Asset allocation is not a short-term strategy for diversifying away the risk of sudden market downturns; no strategy can accomplish that. What asset allocation does accomplish very successfully is to diversify away the risk that comes from being concentrated in a single segment of the market – such as large cap stocks – when that segment cycles out of favor for an extended period of time.

Individual asset classes often go on protracted downturns that can last a decade or more. For example, the period from July 1973-July 1983 saw the S&P 500 trail small cap stocks by 12.8% annually. The market switched around during the 1990’s when the S&P outpaced small cap stocks by over 6.6% annually, then switched back again in the 2000s, with small caps far outpacing large caps by a margin of more than 5%.

Most investors consider “the stock market” to be the Dow Jones Industrial Average, even though the Dow reflects the performance only of the largest of the large U.S. companies. Investors are accustomed to hearing how “the market did today” (which, of course, is how the Dow did) and peg their expectations accordingly. A period of underperformance by a diversified portfolio against the Dow or S&P may make it seem as though asset allocation is not adding any value, but is not an indictment of diversification. It is no different than, say, emerging markets outperforming a diversified portfolio. The simple fact is that a diversified strategy is an amalgamation of its parts (the asset classes); there will always be some asset classes doing well and others underperforming, and there is no telling which ones it will be in any given time period.

Much has been made of “the stock market” earning nothing during the decade of the 2000s, but, as we have made the point before, that was true only for large cap stocks; a well-diversified portfolio enjoyed nice gains during the 2000s. This is the clearest example we can provide of the need to have a diversified portfolio no matter which asset classes – large or small, growth or value, foreign or domestic – is currently leading the pack.

* * * * *

Many analysts are pointing to Citigroup's oft-watched Surprise Index, which is hovering at a nine-month high. The index measures the degree to which economic releases come in above or below economists' forecasts. Its current level is a strong signal that investors and forecasters aren't fully factoring in the underlying strength in the U.S. economy.

            - “Conflicting Risks Put Bonds In A Bind,” (Wall Street Journal, December 17, 2011)

Investors in the past few months have been fleeing the stock market in numbers not seen since the market panic of 2008, stashing their money in cash and bond funds in an effort to escape the volatility that has plagued the market since this summer.

Sure enough, right on cue come a slew of unexpected, positive economic reports. Despite the prevailing gloom over the financial landscape – much of it justified – it is clear that the reports of the U.S. economy’s death have been greatly exaggerated.

The year ahead may well bring further bouts with volatility, but investors would be wise not to underestimate the staggering ability of the U.S. economy to right itself just when the gloom seems deepest.