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May, 2020 Newsletter

Dear Clients and Friends,

These are incredibly challenging times.   The Corona  virus pandemic has brought awareness to the things we take for granted every day – such as sports, concerts, movies, travel, and even grocery shopping – but most importantly, the ability to be in the presence of family and friends.  We are social beings and have had to adjust to this new concept called social distancing.   In times like these, it is difficult to see silver linings; however, they do exist.   A Forbes article summarized some of these items quite nicely. 

  • More time – to read, exercise, paint, fix things around the house, and organize; to name a few.
  • Reflect and reconsider – rethink our habits and routines and make changes.
  • Reconnect and help – feeling like “we are in this together” is showing up in the interesting ways in which we are supporting each other.  This social coherence will have a lasting effect beyond the pandemic.
  • Modesty and acceptance – the virus shows that no matter how well organized we are, things will not always go the way that we have planned.  Whether it is health, airline safety or our calendars, we live in the illusion that full control is possible. The virus can help us create awareness that this is not the case. It provides an opportunity to take a more modest role and accept that many things are simply beyond our control.

It is natural to worry about the economy and the related financial impact associated with the mass closures around the globe.  It is important to take the long view and not get overly preoccupied with the near-term impact that the virus has on economic activity.  We must look forward.

The 60/40 Portfolio in the Rear-view Mirror

Every single prospectus contains the warning, “past performance is no guarantee of future results”.  Yet, we see investors rely on the recent past, time and time again, to project forward.  The Thanksgiving Day turkey is lulled into a false sense of security by his farmer friend, who feeds and cares for him in the days leading up to the third week of November.   For the turkey, and for investors, past is not prologue.  In fact, things are most dangerous when complacency reaches its peak.  For the U.S. stock/bond investor, the leaves have turned brown. 

A portfolio of stocks and bonds has done very well over the last decade, and really, the last 40 years.  These two asset classes dominate the financial industry in terms of coverage and exposure, whether that be CNBC, Bloomberg or Fox Business news in the case of the former; or 529 plans, target date funds, pensions, insurance companies along with the behemoth institutional asset gatherers like Fidelity, Vanguard and Blackrock in the case of the latter.

The industry continues to follow mostly a simple stock/bond strategy in various proportions as a permanent recipe for success.  This portfolio somehow will always magically give us the right amount of downside protection and adequate returns.  Don’t worry about starting yields on bonds or the valuations of stocks.  The stock/bond portfolio will get the job done.  Does this pass the smell test?

Predictive Measurement Tools


The most reliable predictor of high-quality bond returns is the starting yield.   What does the starting yield mean?  In this case, we are referring to the interest rate that would be paid on bonds issued by the U.S. government if they were to issue 10-year Treasuries on a given day. 

The table below provides data points for 3 of the most recent decades.


Actual Bond

Starting 10-yr




Treasury Yield














* Returns are from the Vanguard Total Bond Index Fund (VBMFX)

What is the 10-year Treasury yield today (4/22/2020)?  0.592%

To expect an annual return that is substantially higher than 0.592% annualized would be a detachment from reality.

The role of bonds in a portfolio are to provide: (1) a runway to ride out declines in the stock market or other risk assets, (2) the benefit of diversification to re-balance into risk assets when they decline, and  (3) a positive return that is commensurate with the risk of short-term, modest declines.  Relying on bonds to fulfill this role would be predicated on rates staying where they are or moving even lower.

Note:  If you bought a 10-year Treasury bond today at 0.592% and rates went up to 2.592% two years from now, that bond would trade at a loss of 14.3%.  At 3.592%, the loss would be 20.5%.

Bonds have been to stocks like Robin is to Batman.  At close to no returns, bonds are set up to be a very expensive opportunity cost, or, in the case of inflation, fall at the same time as stocks.   Remember, both asset classes have gone up simultaneously, so do not believe that they can’t move down in tandem.  They are no longer the dynamic duo they once were.

We believe that bond-like substitutes that provide reasonable stability as well as better prospective returns deserve a place in what has traditionally been reserved exclusively for bonds.  Merger arbitrage as well as convertible arbitrage are sensible options.  To get an idea of how merger arbitrage compares to bonds, below is a graph of The Merger Fund, which is the longest standing fund in the merger arbitrage space versus the Vanguard Total Bond Market Index since the inception of the fund from 2/1/1989 – 3/31/2020. 


While it is tempting to hold no bonds at all, there is one environment where they would perform admirably – a deflationary one.  The near-term prospects of which have only increased.


The most reliable predictor we have found for stocks is the Margin Adjusted Cyclically Adjusted Price-to-Earnings ratio (MAPE).   The table below provides data points for the 3 most recent 12-year periods.  MAPE creators have found that 12 years produced the most reliable results.  Admittedly, this is not as tight as the predictiveness that starting yields provide for bonds, but it is an effective barometer.

To summarize MAPE, it measures the amount an investor is paying for $1 of earnings, averaging out earnings and profit margins over a 10-year period.   Let’s break this down. 

  • Earnings drive stock prices.  Earnings = Sales – Expenses.   Neither of these items move in a straight line so using 1 year of data makes little sense.  Outlier years like 2008 (Great Financial Crisis) and 2020 (COVID-19) need to be averaged into profitable years.  They provide no value in isolation.  To account for that, MAPE averages 10 years of earnings.
  • Historically, investors have been willing to pay more or less for each $1 of earnings. For example, S&P 500 investors were willing to pay a staggering 42 times earnings in early 2000 (investor euphoria), but only 14 times earnings in early 2009 (gloom and doom).
  • Buying at a MAPE of 42 versus 14 would have provided an investor a very different return experience.   Buying at a lower MAPE has produced superior returns. 

Actual S&P 500

















* Returns are from the Vanguard 500 Index (VFINX)

At current levels of MAPE, the expected return of the S&P 500 is 0%.

Let’s assume that the predictor for both stock and bond returns are too conservative by 1% annualized for bonds and 3% annualized for stock.  On this basis, the expect return of a 60% U.S. stock / 40% bond portfolio would equate to 2.4% annualized.  

Holding a meaningfully higher amount in stocks for the aggressive investor or a higher amount in bonds for the conservative investor will not have a material impact on this calculation.  At the start of the year, a 60/40 U.S. stock/bond portfolio had the worst expected return since 1929.  With the recent pull back in stocks, things are marginally better.

We want to emphasize that projected returns over a period of time reflects a destination, not the journey.  The journey (month to month, year to year) will certainly not be a straight line.  For example, the 12-year return on the S&P 500 between 1/1/1998 - 12/31/2009 looked like the graph below.  An investor would have enjoyed high double digits returns at the onset, only to give back those returns entirely over the following few years.


While the future returns of U.S stocks project to be underwhelming, allocating away from the U.S. and daring to be different gives an investor a chance to earn substantially higher returns over the next decade.    Cheaply-priced assets have consistently done better than expensive assets over the long term, providing the exposure is broad based – think multi-sector exposure, not individual stocks, which can go from cheap to 0 – or sectors that can stay cheap for much longer than anyone has patience to hold.  What is cheap? 

  • International developed and emerging market stocks, both which have lagged considerably since the Great Financial Crisis.  
  • Value stocks versus growth stocks, which have under-performed by the longest period in history.

Please note that investors rarely enjoy immediate gratification by investing in assets that are cheap.  If we catch the bottom or top of markets, it’s a function of luck, not skill.  However, we can take solace that fundamentals play out over time.  The last time international and emerging markets were glaringly cheap compared to U.S. equities was in the late 1990's.  Using the same time as represented from the graph above (1/1/1998 - 12/31/2009), observe how both continued to under-perform U.S. stocks but then provided a better investor experience over time.


Aggressive Alternatives

The cost of borrowing has huge implications to the price of assets.  Think about what would happen to the value of homes if mortgage rates went to 6%, or at levels that existed in May of 2008.  What would happen to the price of commercial real estate, or any other asset that is heavily bought on credit?  What would happen if corporate borrowing costs rose dramatically?  Would stock buybacks, which have artificially boosted corporate earnings per share, reverse course? 

In these unprecedented times, where the cost of debt is low across the developed world, we believe it makes sense to add alternative sources of risk to compete with stocks.  The key criteria we look for in an alternative is the lack of sensitivity to rising interest rates, or even better, a benefit from rising rates.  Just like timing the stock market, no one has successfully been able to predict rate moves.  They may not rise soon or at all.  However, preparing for this possibility is prudent risk management. 

Admittedly, alternatives require a significant amount of due diligence and their lack of correlation can be frustrating when stocks and bonds are performing well.  Despite this, we believe the diversification benefits far outweigh the cost. 

Please let us know if there is anything we can do to help ease your mind during this difficult time.   If you have concerns about your own situation or that of your loved ones, we are here to help. 

Stay safe.


Ravi Dattani                                                Ryan Cross                                          John Melasecca III