All year long, a distinguished parade of experts soberly explained to investors why stocks were too risky. Bugaboos included:
· The Eurozone crisis in Greece
· The Eurozone crisis in Ireland
· The surging US deficit
· Projected "collapse" of the US municipal bond market
· Risk of "double dip" recession in the US
· Quantitative easing by the Federal Reserve
· Still stagnant real estate market and the tsunami of foreclosures
· US unemployment stubbornly stuck over 9.6%
· Rise of China as a world power
· High gold prices signaling inflation and social unrest
Even so, by November 30th, US stocks gained 7.9%, in line with our 2010 forecast of 8%. Over the next 20 trading days, US stocks gained another 6.9%, nearly doubling the YTD gain to 15.3%. How can this be, given all the negatives above? Stock prices discount the future, not the past. US corporations are lean, mean, flush with cash, highly profitable and earning ever more revenues from international operations. Stock valuations remain at the low end of historical ranges, particularly given the low interest rate environment. When the market offers you good companies on discount, buy! If you wait until all the negatives are addressed (and let's face it, there are always negatives,) the sale is usually over.
How to explain the rally of the last month? Hate to say it but the investors who jumped out of stocks at the March 2009 low of 676.53 on the S&P 500 started jumping back in once 1200 solidified as the current market floor. Well fine, but those investors failed to realize gains of at 75-85% over the last year and a half. An investor who bought the S&P 500 the day Lehman filed for bankruptcy September 15, 2008 is down 4.3% net of dividends. The Barclays (formerly Lehman) Aggregate Bond Index is up 8.5% over the same time frame. An investor with a portfolio of 70% S&P 500, 30% Lehman Aggregate index is down 0.5% through "the worst financial crisis since the Great Depression" if that investor stayed fully invested. Note that these returns are unlevered. Levered investors mostly experienced far worse returns because margin calls stopped them out at market lows.
Our firm failed to comprehend how bad the crisis would be until we were well in. However, we maintained our investment discipline, sold those companies that clearly would not survive (particularly financials like Fannie Mae, Freddie Mac, AIG), held cash aside until April 2009, then went fully invested. As a result, net of withdrawals our balanced clients are at new all-time highs, while our all-equity clients will make new highs over the next year.
30 year bond market rally to end?
Bonds had a good year in 2010, with the Barclays Aggregate index still gaining 6.3% on the year even after falling 1.5% in the current quarter. Aside from a crisis induced low of 2.08% in December 2008, the ten year bond yield has never been lower in the last 56 year
s, touching 2.41% on 10/6/2010. The 30 year slide in bond yields from September 1981 represents one of the greatest bull markets of all time. We have reminded our clients all fall that they have a brief opportunity to refinance current mortgages to fixed rates at the lowest levels we will see for the rest of our lives.
Since early October, the US yield curved steepened dramatically and shifted a percent higher at the long end DESPITE quantitative easing. Quantitative easing is a strategy by the US Federal Reserve to purchase long dated treasuries, thereby putting cash into bank balance sheets, which, in principle, will be used to fund low cost business loans. Because the supply of dollars is sharply increased, the price (interest rate) of those dollars should fall, leading to increased demand for loans, which will fund increased economic output. The mechanism fails if the banks set credit standards too high and just sit on reserves, which is what we see right now. Instead bond investors in generally are dumping bonds because they fear that the increased supply of dollars will just lead to inflation.
However, higher yields attract international investors to the dollar, which has appreciated 5% over the last month - an appreciating dollar is counter-inflationary because stuff bought overseas costs less. What's the net? The US economy will grow slowly at 2% for the next year or two, with inflation slightly above zero. The Fed will start unwinding the current extremely accommodative money policy towards the end of 2011 or beginning of 2012, and that's when risk will increase.
Big picture thoughts - end of empire?
If the talking points of 2010 didn't make us pessimistic, what will? Americans often talk of "American exceptionalism" to explain how a country with 5% of the world's population still produces 24.0% of the world's GDP. The Eurozone produces 28.9% of world GDP but on a higher population base. On GDP per capital basis, Americans produce 31% more output compared to Europeans. Still, US GDP as a percentage of world GDP continues to decline - 46% at the end of World War II, 30% as recently as 2000. All empires come to an end - Egypt was absorbed into the Roman Empire in 30 BCE; Rome in turn was overrun by Visigoths in 410 AD. China was overrun by Mongols between 1125-1279 and entered an 800 year period of cultural stagnation, but did not peak as an economic power in 1820. India was a world power for most of the last two thousand years, but was a colony of the British Empire (conquerors from a tiny island half way around the world) by 1850.
This chart is derived from figures computed by the economic historian Angus Maddison:
In 1 AD, India and China comprised 57% of world GDP, far surpassing the Roman Empire with 14%. By 1973, China and India totaled 8% versus 22% in the US and 26% in Western Europe. Some will argue that China is on its way to once again producing the largest share of world GDP. Perhaps, we say, but not until China's economy transitions from exports to internal consumption, and that is a long and rocky road. We ask: what will mark the end of the American "empire?" Is the US truly NOT exceptional?
Couple of attributes might make the difference:
· While the United States is heterogeneous by population, it is homogenous by laws, governance and currency. Americans are Americans first, New Yorkers, Californians or Alabamians second. Europeans are German, or French, or Polish or Latvian first, European second. Americans can always move more decisively than Europeans (for better or worse.)
· The United States is bordered by two oceans, a long friendly border with Canada and a less friendly but shorter border with Mexico. No other major industrial country has the advantage of secure borders combined with internal transportation fluidity. Japan is surrounded by water, but the interior is mostly mountainous and unusable, and the country is poor in natural resources. Germany is crisscrossed by high-speed highways and railroads, but is completely vulnerable at the borders. Countries like Pakistan have the worst of both worlds - insecure and indefensible borders AND limited transportation infrastructure. Pakistan has a population 55% of the US, but GDP less than 1% of the US.
· The United States is comprised primarily of people who came from somewhere else. While the US is not unique in this regard (Canada, Australia, New Zealand are also countries where "natives" are an extremely small part of the population), it does mean that the US people generally have broken the bonds of family, tribalism and landism (attachment to historic property) to seek opportunities in the new world. Americans are more neurotic, than, say, the Swiss, but are also more driven to succeed economically.
· The American "empire" is generally a cooperative trading empire, rather than an exploitive, extractive empire (for example the British Empire 1700-1938.)
· Our nightmare scenario is a two decade long recession such as the Japanese experience. Americans are far too impatient for that length of stagnation and are far more willing to experience pain (loan write-offs, home foreclosures) to get beyond the current situation.
We're careful not over-generalize from demographic analysis. Did someone born in 1945 really have that different an experience than someone born in 1946? Early boomers (1945-55) had a vastly different experience than late boomers (1956-1965) - cheap education, cheap housing, jobs that provided healthcare and pensions, none of which was experienced by late boomers. What can we conclude about Gen Z (the FaceBook generation?) as this cohort hasn't left high school yet?
Several observations stand out:
· Each cohort is generally less respectful of authority and expertise than the previous, and more cynical.
· Younger cohorts are more likely to value "personal fulfillment" over "sense of duty," which impacts how these cohorts view, for example, marriage or career attachment to a single employer.
· Younger cohorts are less secure and less optimistic about their prospects.
· The leading edge boomers who began retiring in 2010 are woefully undersaved for retirement, which means ever greater demands on national programs such as Social Security and Medicare.
· Later boomers and subsequent generations need to plan for retirement starting at 70, not 60 or 65 as these programs are not affordable in the current "pay as you go" model without adjusting the age cutoffs higher.
In particular, the "Boomer bulge" substantially transformed American society starting with the surge to the suburbs in the 1950's, the vast revolution in education and civil rights in the 1960's, disco in the 1970's, yuppies in the 1980's, healthcare in the 1990's to present, and probably nursing homes and funeral parlors over the next 20 years.
Was does this mean for investment analysis? An older average population generates less economic growth as savings takes precedence over consumption, so we underweight consumer discretionary stocks. We're overweight healthcare stocks as we believe healthcare spending will continue to rise as a percentage of US GDP (Obamacare if anything increases healthcare spending.) Taxes may well go up, despite the recent extension of the Bush tax-cuts, to accommodate higher government spending on healthcare and Social Security. Boomers will be net liquidators of assets over the next 20 years, which includes housing as well as stocks and bonds, to pay for their retirement, which will keep a lid on housing prices and exert downward pressure on stock prices. In looking for growth, we're focused on companies that can grow overseas and also are investing about 10% of our portfolios in international developed stock markets, 5% in emerging markets, to take advantage of what we think is the continued long term depreciation of the dollar.
The biggest risk we see to the American "empire" is the increasingly dysfunctional state of US politics. We're not fans of either of the major parties - our job is to evaluate which party's policies have control of the government and shift our investments accordingly. Still, we marvel at the resurgence of the Republican party in 2010. In 2001, we thought that "grown-ups" had returned to power after the gonzo Clinton years,. The country was at peace, the economy was strong, unemployment was around 3.5%, employers were desperate to find qualified workers, the budget surplus was so large that the Treasury debated ending the issuance of 30 year bonds. Boomers eagerly embraced the stock market to fund their retirements.
Eight years later:
· The national debt exceeded the combined deficits of all previous administrations.
· The US was enmeshed in two nasty guerilla wars in Iraq and Afghanistan at the cost of nearly 6000 American lives and tens of thousands of wounded.
· A gaping hole, the site of 2,752 civilian, firefighter and police officer deaths, remained in the heart of down town Manhattan.
· An entire American city, New Orleans, was lost through inadequate preparation for hurricanes and a criminally negligent emergency response.
· Decades of functional financial regulation were scrapped, leading to the worst financial crisis in two generations.
· Investors lost money in stocks for the first decade since the 1930's.
After such a demonstration of reckless incompetence, you would imagine that voters would never let Republicans anywhere near the corridors of government ever again. Instead, in November 2010 Republicans trounced Democrats in a majority of House elections, reduced the Democratic majority in the Senate from 19 senators to 6 and gained 2 state governorships. Probably the goofiest moment of the 2010 campaign was when Christine O'Connell, candidate for US Senate from Delaware, declared "I'm not a witch, I'm you" in a campaign ad and still won 40% of the vote. So now we have to assume that any partisan, regardless of lack of qualifications, can gain office.
Why does this matter for investments? Because whether you like the trend or not, ever more of how the US society and economy functions will be directed by elected officials. And the citizens who have the temperament to get elected generally don't have the qualifications to run anything.
Already pundits are thinking about the 2012 presidential election. Let's compare two potential candidates:
Michael Bloomberg is the mayor of New York City, who took office while the rubble of the World Trade Center still burned. Re-elected to a third term in 2009, Bloomberg presided over the renaissance of New York City as a world class destination for business and tourism, all the while balancing budgets in the face of a large and unionized workforce, a school system with one million students, worries about future terrorist attacks (and snow removal!) Bloomberg holds a BS in electrical engineering from Johns Hopkins and an MBA from Harvard Business School. He is a self made billionaire and majority owner of Bloomberg LP, a wildly profitable financial news service.
Sarah Palin served 18 months of one term as governor of Alaska, a state with a population of 686,000 (versus New York City with a population of 8.4 million.) Previously she was mayor of Wasilla, AK, population 10,256. She attended 5 different colleges between 1982 and 1987, eventually receiving a BA in communications (journalism) from the University of Idaho. Her work experience includes two jobs as a sports reporter, plus working in her husband's commercial fishing business. She is currently employed as a "reality" TV star and a Fox News "contributor."
Palin has been touted as a likely Republican nominee for the 2012 election, though recent polls put her behind Mike Huckabee, Mitt Romney, and a bit behind Newt Gingrich. Bloomberg is considered unelectable. Not only is he an urban dweller and an East Coast liberal, but he's also Jewish and divorced, and that just won't fly in most of the country. As we noted above, ever larger portions of the US electorate simply don't value experience, authority and expertise. They want someone who "feels" the way they feel, which explains the election of George "W" Bush and Barrack Obama, neither of whom would be on the short list to run, say, General Electric.
Wow! If this is how Americans are going to choose who governs the United States, we're doomed!
Odds and ends
One of our long term holdings, Deckers Outdoor (DECK) appreciated 63% since the start of this quarter, and is up 140% on the year. While we're delighted with the gain, we're also suspicious of such a large move for a company in the relatively mundane business of manufacturing fashion boots and shoes. Turns out, the stock is a current James Cramer favorite, so amateur investors that watch "Mad Money" are flocking to the stock. Where have we seen this chart before?
On the left is the one year chart for Deckers through today; the other is the chart of Crocs, also a shoe manufacturer and previous Cramer favorite, through 10/31/07. Looks great, right? Over the next year, investors in Crocs lost 98.7% of their investment peak to trough. Recently the stock traded at $17.46, a 2300% gain from the low. Unfortunately, we imagine that most amateur investors bought this one high and sold low.
We sold half of our Deckers position in December and will sell the rest in January (to spread the capital gain over two years.)
If you're a current gold investor, you better hope that the price of gold pushes convincingly through the $1400/oz. level (left chart.) When the oil bubble (right chart) burst in July, 2008, the price of oil fell 74% in seven months. We like industrial and agricultural commodities in an environment of rising manufacturing output but own no precious metal (gold, silver, platinum) at this time.
The easy money has been made, particularly in industrials, technology, consumer discretionary and other economically sensitive sectors. Returns in bonds could be flat or even negative over the next several years. We still have exposure to bonds (short maturities only) in our balanced accounts but pared holdings recently, particularly in the corporate sector that gave stock market like returns over the last year and a half. We've substantially increased our exposure to boring old consumer staples, utilities, REITs and telecomm stocks, which offer dividend yields starting at 4% and ranging up to 12%. Bond coupons don't rise with inflation, but stock dividends can. We expect US GDP growth to range between 2-3% over the next 4 quarters. In that environment, we would forecast gains in the S&P 500 of 8-10%, but now we wonder whether December's 6.9% gain has already accounted for most of 2011's stock market returns.