After a difficult 2008 I am pleased to be able to report that the Polygon’s performance rebounded nicely in 2009, with our equity oriented portfolios having gained approximately 10%, net of all fees through June 30. This compares favorably with the Dow (down 2.6%), the S&P 500 (up 3.2%) and the MSCI World Index (up 4.8%).
To extend the comparison, over the 6 years ending in December 2008 (i.e. since the founding of Polygon) our returns have averaged almost 12% per year, while the S&P 500 gained an average of only 4.5%, and the world equity index gained an average of 5.6%. Importantly, we were able to achieve this out performance with lower volatility than equity markets by having substantial amounts of the portfolios invested in fixed income securities and alternatives throughout the period.
With global equity markets bottoming out in early March we were fortunate to have shifted from a defensive, risk oriented posture to a more aggressive asset allocation. Though not normally a great believer in market timing, we engaged in a well timed asset allocation shift out of cash and bonds into stocks starting on March 9 (for your information I am attaching the letter we sent out to clients on that day) which fortuitously was the exact day markets reached their low point.
As a result, at the end of June, we were rather fully invested with less than 5% of our portfolios in cash and an average of 10% held in short term bonds. Other defensive positions were designed primarily as inflation hedges including almost 4% in TIPS and commodity exposure of 5%.
In terms of our out performance a significant portion was attributable to our increased exposure to Asia, which currently accounts for approximately 20% of the portfolios, mostly invested in Greater China, as well as smaller positions in India and Japan. Non Asian emerging markets also contributed with Brazil (4%) and Chile (2.5%) rising significantly.
In more developed markets we continue to have a bias towards defensive sectors with exposure to the pharmaceutical industry in both the US (Pfizer, Johnson and Johnson) and Europe (Sanofi). Though these positions have lagged somewhat in the growth oriented rally we saw last quarter, I continue to value them for their robust cash flow and dividend stream – if they continue to lag the broader market we may well buy more of them. We also have maintained, and in some cases increased, our exposure to the financial services sector. While some of these are, unfortunately, residuary positions which were purchased too early in last year’s precipitous market decline, even with the recent rallies in banking stocks I think they still offer long term value.
Going forward, I believe that the global economy is by no means out of the water in terms of the current macro economic malaise. The de-leveraging process needs to continue and will ultimately be reflected in a reduced standard of living especially in more profligate countries like the US and the UK (which in my mind is not an entirely bad thing). We are already seeing signs of this in higher savings rates and less consumer spending – a trend I believe is likely to continue and will result in below trend growth for some years to come.
However, I do think that the two primary catalysts which have propelled us into this mess – real estate and banking are in the process of healing. Housing prices, having dropped by huge amounts in the US over the past several years, are starting to fall less rapidly and in some areas are rising, while inventories of unsold homes are beginning to come down as builders curtail their activities. With a great deal of help from their Uncle Sam, and other monetary authorities, the banks appear to have stabilized, credit spreads have come down and profits are starting to flow again. In short, the cycle goes on.
One continuing worry that remains is inflation, which though subdued for the moment, could easily re-assert itself over time. With money supply starting to spike in the US in particular, and huge amounts of stimulus being applied by governments all over the world, both monetary and fiscal policy are extremely expansionary. Although capacity utilization remains low and wage pressures are quiescent, the potential inflationary consequences of our current policies continue to concern me.
I was, however, fortunate to have had dinner with Paul Volcker several weeks ago and felt somewhat reassured by the discussion with the former Chairman of the Federal Reserve (someone who knows quite a lot about inflation), who was quite relaxed on the subject. Volcker’s view is that for the next several years inflation will not be a problem because the growth of the US economy will remain below trend averaging only 1%-2%. After that it will be up to the FED to move expeditiously to curtail the inflationary consequences of our current policies.
Regarding market performance for the remainder of the year, my expectations are not overly high. With developed countries having had a 40% rally off the March lows and emerging markets have gained even more than that, I feel equities have gotten ahead of themselves and would not be at all surprised if we witnessed a substantial correction. Nonetheless, over the medium term I believe there are significant opportunities in stocks, particularly in the developing economies. I am also concerned about the value of the dollar given the potential inflationary scenario out lined above and the increasing desire of some foreign countries, like China, to diversify away from the dollar.
For the time being, we intend to continue on the course we embarked on in early March. Relatively conservative, income oriented US stocks, overweight positions in emerging markets, especially in Greater China (though given recent out sized gains in some of those markets we may take some profits), and roughly 20-25% of the portfolio in defensive positions in fixed income and alternatives. Over time I would like to add to the small cap positions outside the US, but given their recent explosive growth, intend to hold off until valuations look more attractive.