Wait For Your Pitch In Today’s Market

February 28, 2013

Investors would be wise to bank some of their outsized 2012 gains.

As we go to print, the U.S. major league baseball clubs’ spring training is getting underway in the warm locales of Arizona and Florida. As a kid growing up in San Diego, I would eagerly await the start of the Padres season. But I had no false hopes. The Padres were perennial “cellar dwellers,” falling off the Pennant-chase pace quickly; glancing at the standings in June was a rarity. Inevitably, the second half of each season saw us turning our attention to the batting race where Tony Gwynn, known as “Mr. Padre” and arguably the greatest hitter of his generation, would compete for the highest batting average in baseball. In the 1994 season, Gwynn finished with an average of .390, just off the magical .400 mark last achieved by Ted Williams, coincidentally a native San Diegan, in 1941.

Of course, Williams was the gold standard of hitting. Gwynn, like many players, would seek his counsel to discuss the science of hitting. Before even talking about the mechanics of a swing, Williams instructed all would-be hitters first to develop the mindset to “get a good ball to hit.” He expounded further that “…a good batter can hit a pitch that is over the plate three times better than a great batter can hit a questionable ball thrown to a tough spot. Pitchers still make enough mistakes to give you some in your happy zone. But the greatest hitter living can’t hit bad balls well.”1

Investors, especially those in the asset allocation game, would also be wise to follow the “Splendid Splinter’s” advice. Most asset classes, coming off an impressive record in 2012, are “high and outside” the valuations necessary for future big league returns. Patience is the name of the game today.

Bumpy Path to Real Returns
Unquestionably, 2012 was a very rewarding year in the capital markets. Long-time readers are well acquainted with our equally weighted 16-asset class portfolio as a quick reference for asset allocation opportunities across a global spectrum of exposures.2 Last calendar year, this simple equal-weighted construct would have produced a return of 11.5%. After deducting 2012 inflation of 2.3%, the real return from this mix exceeded 9%. The less diversified but far more ubiquitous 60/40 blend of the S&P 500 Index and BarCap Aggregate Index—what we label a two-pillared portfolio of mainstream stocks and bonds—produced a near-identical return at 11.3%, also earning 9% in real terms.

The breadth of the bull market was also substantial. Only commodities posted a negative return, and that was a paltry 1.1% loss for the Dow Jones UBS Commodity Index. How many investors expected these kinds of returns as we entered 2012? Not many after the debt downgrade in August 2011 and the near-meltdown in Europe during that same timeframe.

Of course, one year’s returns, however good or bad, don’t make or break long-term investment programs. Retirement nest eggs and endowments seek to harvest meaningful real returns, usually centered around 5% above the rate of inflation, over time periods lasting decades. And the past quarter century squarely supports these assumptions. Indeed, we witness a real return of 6.4% since 1988 for the equally weighted 16-asset class portfolio.3 A 60/40 blend was only slightly less at 6.2% per annum after inflation, albeit with a bit more risk.

But most investors are surprised to learn that a diversified portfolio’s results falling around the hallowed CPI + 5% is an unusual outcome, at least on an annual basis. Figure 1 displays the calendar year real returns for the 16-asset class portfolio, with the 60/40 asset mix thrown in for good measure. Note the dearth of examples—only 3 in 25 years—where the equally weighted portfolio finished in the seemingly wide range from 3% to 7% above the rate of inflation. The 60/40 investor also came within 2% of the 5% real return target only twice. It just doesn’t happen very often. Instead, the capital markets provide a feast-or-famine history of big “up” years, offset by modest to severe shortfalls, often during crisis periods. Real returns that are negative or soar into double digit territory are more common than returns between these two poles! The average isn’t normal.

 

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