If you went off on safari in September 2008 and had no media contact until yesterday, a quick check of your portfolio and you'd conclude that nothing happened while you were gone. As we all well know, we had a horrific sell-off of all assets in the 6 months through March 2009, followed by one of the steepest rallies of all time. As we have observed
time and time again investors, both individuals and institutional clients, historically "buy high and sell low." A record $72 billion poured out of equity mutual funds in October 2008 on top of $56 billion in September. Those investors who sold equities, corporate and municipal bonds, preferred stock and any other non-Treasury securities in March 2009 captured 13 year lows! The modest inflows since April 2009 imply that investors mostly missed out on the subsequent rally - they will never be able to make up the performance gap.
We were caught off balance by the October 2008 meltdown as much as any investment advisor. However, we stayed true to our principles of:
· Investing in real companies with real products, real revenues and real earnings.
· Avoiding fads (emerging markets, hedge funds, private equity)
· Mixing in fixed income to provide reliable minimum returns, either for clients who are already retired, or clients with short-medium term needs (next 1-5 years.)
· Helping our clients sort between short term and long term needs and allocating riskier assets such as equities to the long term component of their investment allocation (e.g. retirement accounts.)
· Maintaining conservative draw rates on portfolios of no more than 4-7%/year.
· Avoiding the use of leverage, which compels investors to sell not when they want to but because they have to.
As a result, we have fully participated in the rally of the last 8 months and expect our clients to start making new highs in their portfolios (relative to October 2007) in about two years. We are particularly pleased that, among our retired clients, we didn't need to reduce anyone's monthly "allowance" as we draw those monies from bonds and bond funds. Clients who invest monthly or quarterly through systematic investment plans, either with our firm or though their 401K's at work, gained disproportionately.
We recently received the annual update of the "Quantitative Analysis of Investor Behavior," which is published by DALBAR, a market data research company focusing on the financial services industry. We would be happy to provide a complimentary 14 page summary to our clients because we believe that this study's conclusions crystallize the strategies we have employed for years. We hope to spend much of 2010 working more deeply with our clients, not just on the stock, bond and mutual fund assets we are directly responsible for, but also our clients' 401K, Employee Stock and Stock Option plans and College Savings Plans. We found over the last year that those clients who had successfully compartmentalized their assets by purpose were most able to resist making bad decisions.
Next month's newsletter will be devoted to explaining "Purpose-Based Asset Management" in detail. The rest of this commentary will focus on the length and shape of economic recovery in the United States
Current US Economic Conditions
US Q3 GDP surprised with a gain 3.5% for the first estimate released at the end of October. This report is subject to two additional updates over the next two month, so could the number could be revised lower. Forecasts for Q4 average 3.0%, with gains forecast of 2.6% in 2010 and 3.0% in 2011. If these numbers were achieved, they would exceed the averages of the 2002-2007 period, which was generally regarded as a prosperous time.
Unfortunately, the unemployment rate, currently 10.2% may well remain elevated for the next several years. Construction provides many non-exportable manufacturing jobs, and we expect that sector to remain depressed by half indefinitely. Meanwhile, hundreds of thousands of jobs tied to the real estate industry (brokers, mortgage originators and servicers) are also permanently destroyed. Millions of low tech manufacturing jobs have moved permanently to China. As a result, the number of Americans employed now (131 million) is the same numbers as at the start of the decade, while the US population gained 27 million from 281 million in 2000 to 308 million as of October 2009. 7.3 million jobs disappeared just since the start of the current recession in December 2007. During the previous expansion (2003-2007) job growth gained 8.0 million or an average of 130 thousand/month, of which 10 thousand/month were necessary just to keep up with population growth. Over the next 5 years, the US would have to add about 15 million jobs to get the unemployment rate back down to 5%.
The critical issue remains whether the US Treasury and Federal Reserve can successfully back away from the liquidity programs that were put in place over the last year to "save" the system. At present, the Federal Reserve is effectively recapitalizing the banking system by lending funds at near zero and allowing the banks to invest the loans right back in Treasury bonds yielding 0.76-4.25%. The largest US corporations have rushed new bond issues to market this past quarter, taking advantage of exceptionally low rates now that spreads over Treasuries have returned to normal. Meanwhile, medium and small businesses are complete cut off from credit. So those businesses, which are responsible for most job growth in the US, simply won't hire right now. Ironically, the health care proposals currently under consideration in Congress have caused insurance costs for small businesses to soar as private insurers fear higher costs in 2010, further depressing job growth.
The good news is that if you do have a job, now is a pretty good time to be a consumer. A falling dollar and rising energy prices are inflationary, but overall inflation remains extremely low in the face of low capacity utilization, deep discounts on most purchased goods, and national incentives to invest in housing (not to mention the just expired 'cash for clunkers" car purchase program.) 2009 holiday sales are currently forecast to rise or fall 1% relative to 2008. Actual results will tell us a lot about consumer psychology. Earlier this year we talked about how "doom fatigue" had set in. Our current perception is that consumers, while still aggressively paying down credit cards and other debt, and boosting savings, are in the mood for a little fun.
The Alphabet Soup of Recession Recovery
So what are the possible scenarios over the next 5 years for the United States? The best scenario, and also the most unlikely, is a "V" shaped recovery, where the economy rebounds as fast as it fell. Without the lax lending policies that fueled over-spending in housing from 2000-2007, we're not going to see the necessary gains in jobs in a short enough time frame.
More likely, job growth over the next 5 years occurs at a modest rate, creating a "U: shaped recovery. The recovery from the 2000-2002 recession (also known as the "jobless recovery") could be a model for what to expect over the next 5 years. Job growth occurred at a rapid clip during that period, unfortunately primarily in India, China and Brazil as those countries ramped up exports to the US.
The 1980-83 recession in the US followed a "W" shaped pattern. A short sharp recession from January-July 1980 was followed by a period of sharply increasing inflation. The Volcker Fed aggressively raised short term rates, creating a second recession with unemployment peaking over 10% by 1983. The risk that the current Fed faces is winding down its current support programs fast enough to avoid inflation, but not so fast as to destroy rising confidence in the banking system.
We think the most likely scenario is a "J" shaped recovery, where future US GDP grows at a 1.5-2% rate, well below the 3% rate that prevailed from much of this decade, because consumer dollars spent on paying off debt and building retirement assets are not dollars spent on consumption that generates economic growth. Also, it's possible that, as in Europe, unemployment in the US moves to a permanent higher plateau.
Our nightmare scenario is an "L shaped recovery, which describes the Japanese economy ever since their housing and stock market bubble burst in the early 1990's. GDP in Japan is at the same level today as in December 1992, so net no gains in 17 years. There are structural and cultural reasons why we don't think that scenario will play out in the US (Americans are not that patient!) but it's something to worry about.
As of mid-November, stocks are at the top of the trading range we see between 1000-1100 in the S&P 500 through year end. With stocks at 13 month highs, a number of clients have asked us in recent weeks, "Shouldn't we go to all cash? What if the markets plunge again?" We've spent a lot of time this fall looking at other financial crises of the last 30 years, trying to pick out common characteristics. Two factors stand out: 1. issuance of "securities" that plainly are not and 2. overuse of leverage. Prominent examples of the first factor are "junk bonds" during the late 80's LBO craze, "dot com" equities in the late 90's and "sub-prime" mortgage bonds issued this decade. Overuse of leverage was seen in the 1998 Long Term Capital crisis, and of course in the current crisis.
These factors are like the dry brush that triggers a forest fire. After the fire passes, it takes time to for fresh kindling to accumulate, so we're not worried about an immediate financial collapse. At the same time, our previous assumption that "grown-ups" were in charge of the financial system clearly was tested and found wanting. Going forward, we have to be more proactive in dialing down risk as others take on risk. We used to think that a major financial crisis could occur every generation, but perhaps we should expect them as often as once every 8-10 years. At least for now, we're satisfied with our investment allocations.