GreyOwl Capital Q4 Letter
S&P 500 earnings grew approximately 9% for the two-year period from the beginning of 2012 through the end of 2013. Over that same period, the total return for the S&P 500 index was close to 50%. This implies a 35% increase in valuations – i.e. investors were willing to pay 35% more for the same stream of future cash flows.1
In that context, we find the market’s January “breather” completely rational. Will it continue?
We have no idea. However, we do know that long-term (i.e. sustainable) stock market returns are anchored to corporate earnings growth. S&P 500 returns will not exceed earnings growth indefinitely. Additionally, we know that significant government market interventions (both fiscal and monetary) are eventually destabilizing. Like water finding a crack in a dam, market forces eventually overwhelm manipulation. Whether it was fear regarding the Federal Reserve’s “taper” that acted as the primary trigger for the January correction, no one can be sure. We are sure that a central bank cannot quadruple the size of its balance sheet over a five-year period and completely avoid negative consequences.2
At Grey Owl, we focus on building an investment portfolio that can perform well in most environments – not one that is betting on inflation vs. deflation or growth vs. recession. This portfolio provided solid absolute returns in 2013 – a late-stage, roaring bull market. Critically, what was in effect the same portfolio3 also held up well in January’s equity market selloff.
In this letter we aim to put 2013 equity market returns in broader historical context, discuss current market sentiment, and highlight recent portfolio changes. First, here is the standard performance table for the Grey Owl Opportunity Strategy as of December 31, 20134:
|Grey Owl Opportunity Strategy|
|Spider Trust S&P 500 (SPY)|
|iShares MSCI World|
|(ACWI and MXWD)|
The S&P 500 – Equity-like Volatility with Fixed Income Returns
We suspect money management firms will not be rushing to trademark the above “marketing slogan,” but it does accurately capture the last decade-plus of long-only equity market investing. Since the beginning of 2000 through the end of 2013 (fully fourteen years), the annualized total return for the S&P 500 index has been just 3.6%. In order to achieve this meager return, investors had to suffer through two 50%+ peak to trough declines.
Over the same period, fixed income (as measured by the Barclays Aggregate US Bond Index) provided a total return of 5.7% annualized with only modest drawdowns: better returns and a smoother ride.
Our point is not to argue that bonds are better than stocks. Today, valuations for both asset classes portend meager returns going forward. Rather, our point is that 2013 is only one year. Those playing the game with a long-term focus should keep two things in mind:
1) Starting valuations eventually matter. Equities began 2000 with a price to earnings (PE) ratio of 30. Equity returns were set up to be poor in 2000 and they have been over the
full fourteen-year period since. Unfortunately, at 19 today, the PE on the S&P 500 is still 20% higher compared to the historical average of 15. 5
2) Over a full cycle, a balanced portfolio can provide comparable returns to a pure equity portfolio with significantly less volatility. This is particularly true if gold, which is
consistently negatively correlated to both stocks and bonds, is included. For example, Wainwright Economics6 recently described the returns for a 15% stocks, 70% bonds, and 15% gold portfolio from 1970 through 2013. This portfolio compounded at an average annual rate of 9.29% with just a 6.92% standard deviation. The S&P 500 index compounded at 10.23% with a 15% standard deviation over the same period. Said differently, Wainwright’s version of an “all weather” portfolio provided 90% of the
return with less than half the volatility.7 Additionally, this portfolio has proven mostly immune to surprise shifts in economic growth and inflation/deflation.
A Speculative Consensus
While equities have underperformed bonds for fourteen years, the Federal Reserve’s ongoing “financial repression” combined with 2013’s exceptional equity market returns have served to create a loud chorus championing equities as the asset class of choice today. The lead story in the January 10, 2014 issue of Grant’s Interest Rate Observer summarized this well. “As we read the new year consensus of investment sentiment, people love stocks, hate bonds and feel sorry for gold. ‘In the many years I’ve been surveying experts for their predictions for the coming year,’ writes New York Times’ columnist James B. Stewart, ‘I cannot recall another time when optimism about the stock market, the economy and corporate profits was so widespread. As is pessimism about the bond market.’”
Grant then opines, “Perhaps the trader’s maxim applies: ‘If it’s obvious, it’s obviously wrong.’” Perhaps the trader’s maxim does apply. Investors appear to be crowding onto one side of the boat. We “ tweeted” as much on December 3rd.
We went on to discuss in more depth the risks of elevated margin debt levels in a January 31st Seeking Alpha post “ Why Margin Debt Matters.” The article is reprinted in its entirety here.