“90% of what passes for brilliance or incompetence in investing is the ebb and flow of investment style.” – Jeremy Grantham, GMO

The U.S. equity markets have far outpaced the international markets over the last few years. There are several reasons to explain the drivers behind this divergence in performance. The main driver, in our opinion, has been the aggressive monetary policies of the Federal Reserve (Fed) which has helped the U.S. economy recover faster than those in other developed nations. The other global central banks led by the European Central Bank (ECB) and Bank of Japan (BoJ) have also started on this path of balance sheet expansion, but they have obviously lagged the U.S. Fed’s pace. In the table below, we summarize the annualized total returns for the S&P 500, MSCI EAFE, and MSCI Emerging Market (EM) indices since January 2009, and compared those returns for the previous 12 years prior to the credit crisis. The U.S. equity markets have led dramatically in the past 7 years. This divergence has been especially pronounced in the last two years. The annualized returns, however, were much closer in the previous 12 years, and the MSCI EM Index actually led all the indices, mainly due to the rapid growth in the Chinese economy.

Index Jan. ’09-Feb. ’15 Jan. ’96-Dec. ’07
S&P 500 +16.7% +9.4%
MSCI EAFE +10.4% +8.5%
MSCI EM +12.0% +11.2%

Source: Bloomberg

Given the lackluster performance in the last few years, many investors are questioning whether geographic diversification adds any value to a portfolio anymore. Furthermore, some of our domestic equity managers also invest in international companies, which have contributed to their performance lagging the domestic indices. We would take a contrarian view in answering the above question. As we pointed out in our year-end Client Letter, we view the valuations in the U.S. equity markets to be stretched relative to history. We also believe, regardless of the recent underperformance, the case for investing in international and emerging market equities remains a compelling one. Therefore, we have favored managers with global mandates who can source opportunities regardless of where a company is domiciled. Furthermore, the run up in the U.S. markets over the last few years has resulted in much higher valuations relative to the international markets. In the table below, we compare the relative valuations of the global equity indices.

Index Price/Earning Price/Book Dividend Yield
SPX 18.6x 2.9x 1.9%
MSCI EAFE 17.7x 1.7x 3.3%
MSCI EM 12.4x 1.5x 2.7%

Source: Bloomberg

Many of the leading global companies in technology, healthcare, industrial, media and other sectors are domiciled in the U.S. Also, the U.S. companies have been very fast to adapt to a changing macro environment following the credit crisis. Nevertheless, we believe there are excellent companies overseas as well. Our job as fiduciaries is to hire managers with deep research teams and expertise whom we believe can best uncover those hidden values over time.

Sasan Faiz
Co-Chief Investment Officer

“If the policy is in error, expect a policy error.” – Tad Rivelle, CIO – TCW

On several occasions in the past, we have articulated our belief that the U.S. equity and bond market valuations are stretched. We have also argued that Zero Interest Rate Policies (ZIRP), practiced by the U.S. Federal Reserve (Fed) and other global central banks since the credit crisis, have led to investors chasing higher yields and risk assets without much regard to risk. The Fed’s balance sheet has experienced tremendous expansion since the onset of the credit crisis. According to Guggenheim’s global CIO Scott Minerd, the Fed’s balance sheet now represents roughly 26% of the U.S. economy. While the Fed just recently concluded its bond buying or “quantitative easing” program, it is still not clear how or when the Fed will start to drain some of this liquidity or raise short-term interest rates. Other global central banks have also experienced similar balance sheet expansions relative to the size of their economies. In a recent presentation, CIO of TCW Tad Rivelle shared some of his concerns that the Fed’s monetary policies have distorted valuations in the credit markets. He also stated that the US is currently in a late stage credit cycle, and a rise in volatility should be interpreted as a warning signal in this environment.

As fiduciaries, we believe it is our responsibility to point out such risks in the global financial markets and try to take appropriate steps to protect our clients’ portfolios. For over a year, we have believed that a small allocation to gold or gold mining shares represents an important hedge against super-accommodative monetary policies and the resulting erosion in the value of the US Dollar (USD). According to Bloomberg, the USD Index has lost over half of its value relative to a basket of foreign currencies since the mid 1980s. Nevertheless, the USD has been relatively strong lately versus other reserve currencies (The Euro and Japanese Yen). In our opinion, this is mainly due to the perceived diverging monetary policies in the US and other developed nations.

Focusing on risk adjusted returns and protecting against the downside in a portfolio require us to be contrarian investors at times. This means trimming our allocation in riskier assets that have appreciated and raising our allocation in assets that have lagged and are out of favor. It is no secret that an allocation to gold mining shares has not worked well in the past year. In a properly-diversified portfolio, we do not expect all parts to move in the same direction at the same time. This, however, has not changed our view that gold serves as true “global currency” and the need for such a hedge has never been stronger. While short-term market volatility is never a welcome addition to a portfolio, we believe the true risk in a portfolio is the risk associated with the permanent impairment of capital. By introducing this hedge or slightly increasing our allocation in some portfolios, we are attempting to somewhat mitigate this risk.

If you would like to discuss the rationale behind this move or your portfolio in more detail, please do not hesitate to contact us.
Sasan Faiz
Co-Chief Investment Officer