By Tom Bradley

It’s been a dramatic year in the capital markets. Interest rates moved up meaningfully in the spring and stocks have been on a roll all year. Indeed, U.S. and international stocks have been going up steadily for two years.

Enough has happened that it’s time to update our advice to clients and specifically, what we’re doing in the Founders Fund. Since inception, the fund has had a full allocation to stocks (i.e. either side of the long-term target of 60%). As prices and valuations have moved higher, however, we’ve brought the weighting down (in hindsight, this has worked against us given the strong markets). From a high of 63% in mid-2012, the Founders Fund equity weighting is now 58%.

In the coming weeks, we’re going to continue to bring stocks down. Valuations have gone up (i.e. prices have risen more than earnings), such that price to earnings multiples (P/E’s) are at the high end of a normal range. Multiples in general are up about 2 points, from roughly 16 times earnings at the beginning of the year to 18 currently. This level is not overly stretched in my view, but there is less cushion and more downside if the market runs into turbulence.

Certainly, there’s no easy answer as to what stocks will do over the next few years. Relative to bonds, they still look attractive. The spread between bond yields and earnings yields has narrowed, but still points to higher returns for stocks (5-7% per annum) than bonds (1-3%). In other words, interest rates would suggest that P/E multiples should be higher than normal.

On the other hand, the debt issue is a growing concern. So far, governments and central bankers are fixing the problem with easy money and more debt. Both players are intent on kicking the can down the road in hopes of getting employment back to normal levels. Unfortunately, we’re not in normal times. With central banks interfering with the natural flow of the capital markets, I believe the political/economic risk is still very high. Extreme leverage leads to extreme outcomes (good and bad), and usually results in suboptimal but politically charged decisions.

All of that to say, we are running counter to how many investors are feeling today. While those who are underexposed to stocks watch the markets rise and are anxious to get on board, we are becoming more cautious. With the latest run, future return expectations have come down, not gone up.

The stock weighting in the Founders Fund is now below where I prefer it to be long term and the fund still has a healthy cash reserve (15% of total assets). The exposure to bonds is light (28%), although it has edged up as stocks have come down. To our way of thinking, now is a time for patience. To use Warren Buffett’s baseball analogy, we can afford to watch a few pitches go by while we wait for a really good one. There aren’t many fat pitches right now.