2002 Year-End Review and Commentary

By Bob Marshalla

January 10, 2003

Summary

Through fits and starts, the equities markets regained some ground in the fourth quarter of 2002, with the S&P 500 gaining 8%. Still performance for the full year was strongly negative both here and abroad. The S&P 500 lost 22% for the year, while foreign stocks (as measured by the EAFE index) declined by 16%. The bond market in contrast had a stellar year, with the Lehman Brothers Aggregate Bond Index up10% (that’s a really good year for bonds!). Real estate, the third top level asset class in which our clients are invested, had a middling year, with equity REITs earning 5% (based on the NAREIT Equity Index). While this was great compared to equities returns, it fell far below the average returns of 20% that REITs had generated over the two previous years. Table 1 provides a snapshot of 2002 market returns for these top level asset classes, as well as for many of the important second level equity asset classes (like growth versus value and large cap versus small cap).

Our clients who are heavily invested in equities (which includes most of you) have of course suffered as a result of the down market.  Only a grossly undiversified and exceptionally lucky equity portfolio could have been made money in this market environment, and this kind of “bet the house” approach is decidedly not the kind that is employed for Marshalla Asset Management clients. Still our clients have continued to enjoy excellent performance relative to the market, and remain in position to benefit strongly when the market does come back to life (and it will!).

In the following paragraphs, I provide further commentary about equity and fixed income market performance, our investment approach and about how to form reasonable expectations for the future.

Equity Market Performance – Past and Future

So that makes three in a row. The stock market has now declined for three straight calendar years, marking the first time this has happened since 1939 – 1941. As measured by the S&P 500, the U.S. market declined by 22% in 2002, which follows up on declines of 12% and 9% in the previous two years. And this time, the decline was pretty much across the board, large caps and small caps, domestic and international, growth and value, as well as all major industries.  The only equity asset class we follow that generated positive returns in 2002 was small cap international,^[1] which increased by a shade under 2%. 

 

 

 

 

Still, going forward it’s not as bad as it looks for several reasons. For one, when this down cycle began in March 2000, there was truly a huge amount of “irrational exuberance” to be wrung out of the market. The compound annual return of the S&P 500 for the last five years of the 1990’s was almost 29% per year, and the PE’s of even supposed blue chip tech companies had reached or approached triple digits. The late 90’s saw a bubble that will be a prominent chapter in all future books on booms and busts. So despite three terrible years in a row, the S&P 500’s compound annual returns for the eight years including the late 90’s is now at a positive 10.2% per year, just half a point below its long term average (since 1926, that is).  And by fundamental valuation metrics, the market as a whole has now reached the state of being under-valued, or at worst, fairly valued. So it is fair to say the excesses of the 90’s have now finally been wrung out of the market.

Scant relief for those who have ridden the market both up to and back down from its peak, I know. But here is the second reason for optimism: It is in periods like this that an intelligent investment approach can deliver exceptional relative returns. One way to do this is to always pay close attention to the prices of equities relative to their intrinsic values. Repeat this mantra: “the price always matters”.  Now say it again, and one more time to be sure. This is what value investing means to me, and it really has little to do with whether we own slow growth or rapid growth stocks[2].  This is the basis of the approach I use for choosing individual stocks, and it is the approach I look for in selecting managers of equity mutual funds. This sounds simple and it sounds like common sense, but believe me, this is not the conventional wisdom on Wall Street or even amongst investment advisors.

While my notion of value investing differs from conventional definitions, it is still revealing to look at the commonly used benchmarks for measuring the performance of growth and value stocks, such as those issued by the Russell company. What we find is that during the late 90’s, the value class actually behaved reasonably normally, with total returns only modestly greater than over the long term.  It was the growth class gone mad that produced the bubble. But since the bubble began to burst in March of 2000, value has trounced growth for three years in a row, and this is why a value-tilted portfolio has had a huge edge in this market environment. For the US market as a whole (measured by the Russell 3000), total returns for growth stocks lagged those for value stocks by a whopping 13 percentage points in 2002 (as shown in the second and third rows in Table 1). For the previous two years, the outperformance was even greater, at 15% in 2001 and 18% in 2000.  Further, value has beaten growth for the trailing 5, 10 and 15 year periods as well. And the outperformance of value has applied separately to both large cap and small cap stocks alike, as demonstrated in Table 2. In fact, the outperformance of value has been substantially greater for small cap stocks than for large cap stocks.

To be fair, over recent decades, performance leadership has cycled between growth and value (at least for larger cap stocks[3]), with each style typically holding the lead for several years at a time.  But the most important result in my opinion is that over longer time periods, matching our clients’ investment time horizons (i.e., 15 years or more), value has consistently delivered higher returns than growth, while having less (not more!) volatility.[4]  There is debate about whether this should be considered a market inefficiency, but whether it is or not, it is a well documented, long running market characteristic. Assuming it continues in the future, and there is no compelling reason to think it won’t, it is something that that can be exploited by patient, disciplined investors.

And finally, a third reason for optimism is that the MAM investment approach has been working well in practice, as evidenced by the good relative returns my clients have enjoyed. For the past three years the average of my client’s portfolio total returns has exceeded the equity market’s performance by amounts ranging from the mid to upper single digit percentages.

This level of relative market outperformance is probably above what anyone could honestly promise to maintain over the long term. But the good news is that on an absolute basis, the opposite is almost surely true. Equity market performance for the past three years has, with virtually no doubt, been far worse than we can expect it to be over the long term future.

What is the fair value of the market today? And what level of total returns should we expect equities to generate in the future? I have spent a great deal of time evaluating these questions over the past year, and I have come to the following conclusions[5]. Over long-term investor horizons (which generally means at least 10 years) equities will probably yield lower returns on average than they have over the past 80 years or so, but will nonetheless continue to be more profitable than fixed income or any other kind of readily available investment classes. Another way this can be stated is that the equity risk premium, which is the excess return traditionally enjoyed by investments in equities as compared to risk-free government securities, will be a few points lower than it has been on average over the twentieth century. But these returns should still be quite attractive on both an absolute and relative basis.  I expect the broad US and world equity markets will generate long term compounded annual returns in the upper single digits (i.e., 7% to 9%), which should remain several points higher than the fixed income benchmark returns.

But there is more good news. The analysis above assumes that equities are starting from a fair value plateau. If instead the market is undervalued today, then it would need to make a significant move upwards just to reach the fair value plateau from which it would grow at the rates suggested above.  Furthermore, based on conservative assumptions and fundamental analysis, the U.S. equities market does appear to be undervalued as of year end 2002. Though such analysis is far from certain, the undervaluation as of year end appears to be in the range of 20 - 30%. 

Just when the market may return to fair value, or whether this will happen via a short outburst or a long gradual incline, is anyone’s guess.  In fact, it is quite possible the market could become even more under-valued than it is now before resuming its long-term upward trend.  But my best guess is that at some time in the next three to five years we will enjoy a period of strong double digit returns, followed by a longer period with average returns in the upper single digits.

Fixed Income Market Performance – Past and Future

Bonds turned in their third straight year of strong performance in 2002. The Lehman Brothers Aggregate Bond index that covers the whole U.S. bond market was up 10.3% for the year, following up on total returns of 8.4% in 2002 and 11.6% in 2000. Bonds have delivered cumulative returns over the past three years of plus 33% (based on the Lehman Bros. Aggregate Bond Index) while U.S. stocks produced a cumulative loss of 36% (based on the Russell 3000 index). So bond performance has been the mirror image of equity performance, which helps to illustrate the benefits of diversification.

Does this mean investors should increase their allocations to fixed income? In general, the answer is no.  It is not at all unusual that bonds should outperform equities for a three-year period.  Still, bonds have not returned nearly as much as equities have over longer time periods in the past, nor do I expect that they will in the future.  The excellent recent bond performance springs directly from the concurrent trend of declining interest rates. With interest rates about as low as they can go now, we should not expect this trend to continue for the next three years. On the contrary, it is more likely that interest rates will begin to rise at some point within that time frame.

Like the equity market, the bond market is quite diverse, and a sound investment plan calls for diversification over the numerous fixed income sub-categories. Table 3 provides a list of some of the important fixed income sub-categories amongst taxable bonds, along with a good representative mutual fund for each. In fact, all of the named mutual funds except for the first one are utilized in many MAM client portfolios. The table also shows the total return performance for each of the representative funds in 2002, their current SEC yields (as of December 31), and their weighted average duration and quality ratings.

Given that the decline in interest rates has fueled most of the recent strong bond market performance, it should come as no surprise that the longer duration bond categories fared the best. Since we don’t expect this trend to continue much longer, is there any other source of potential good future performance for bonds? The answer is yes, and it lies within the “spreads”, which refers to the differences between the yields of higher and lower quality bonds. 

These spreads, whether measured as the differences between Treasury bonds and investment grade corporates, or between either of those types of bonds and high yield corporates, are currently at all time highs. What drive these spreads are general economic conditions, as well as the prospects for the individual issuers. As the economy improves, and as companies in certain depressed sectors start to regain their health, these spreads will decline, and declining spreads implies relative outperformance for the lower quality bonds. So within Table 3 for example, declining spreads would be expected to cause high yield bonds (the worst performing, but highest current yielding category in the table) to enjoy better relative performance going forward than long-term government bonds (the best performing category in the table last year), as well as compared to investment grade intermediates. In addition to being more sensitive to spreads, lower quality bonds are less sensitive to interest rate changes. So looking forward, if the economy improves rapidly, we might expect to see improving quality ratings, declining spreads and rising interest rates.  In this environment, the lower quality (i.e., “high yield”) bonds would outperform.  If instead, the recovery remains feeble, so that quality ratings stay where they are and interest rates stay low, then the higher grade bonds would likely continue to perform better. Of course no one is sure what will happen next, so the prudent course is to hold some of each kind.

 

Table 3 - Bond Fund Performance and Portfolio Data
			2002	Current	Average	Average
			Total	SEC	Duration	Weighted
Fixed Income Category		Representative Mutual Fund	Return (%)	Yield (%)	(Years)	Quality
Investment Grade, U.S.
	Long Term	PIMCO Long Term US Gov't Inst'l (PGOVX)	18.9%	4.3%	11.3	AAA
	Inflation Protected	PIMCO Real Return Inst’l (PRRIX)	17.0%	4.2%	5.8	AAA
	Intermediate Term	PIMCO Total Return Inst’l (PTTRX)	10.2%	4.2%	3.8	AA+
	Short Term	PIMCO Short Term Inst'l (PTSHX) (PSHDX)	2.9%	2.9%	0.2	AA
High Yield, U.S.		PIMCO High Yield Inst’l (PHIYX)	-0.9%	8.8%	3.8	BA
		Northeast Investors Trust (NTHEX)	3.2%	8.6%	5.4	B
Foreign Bonds		PIMCO Foreign Bonds (PFORX)	7.6%	5.0%	4.8	AAA
		DFA Five Year Global Fixed Income (DFBGX)	10.4%		up to 5	AA & up